The municipal bond market faced strong headwinds in the first half of 2025, with tariff and budget policies, including debate over the One Big Beautiful Bill Act (OBBB), weighing heavy on investor sentiment.
It’s understandable that the headlines made investors jittery, but it’s important to look beneath the surface noise at the underlying muni bond market. Based on our assessment, it’s inherently sound and dotted with tax-advantaged opportunities for active, focused and flexible investors.
Weathering a Challenging Environment
Besides the weight of negative policy headlines, the municipal market faced record supply: new issue supply is up 16% year-over-year and 49% over the trailing five-year average. Heavy supply tends to pressure returns, but inflows into muni funds—$17 billion through June 30, 2025—have helped absorb considerable excess inventory.
Supply will likely continue to be the key challenge in 2025 and with average construction costs up 35%, municipalities need to issue more debt to pay for capital improvements. Issuance is also up as more state and local governments reenter the debt market while COVID 19-era stimulus winds down. State and local governments were also pulling forward issuance due to lingering concerns around muni bonds losing their tax-exempt status.
Checking in on the OBBB
Muni bonds may have dodged a bullet relative to the OBBB, considering lawmakers initially had floated the elimination of munis’ tax-exempt status to offset the bill’s other tax cuts. The idea didn’t gain traction and, based on several important reasons, we’re convinced wholesale elimination is on hold indefinitely.
The OBBB may still pose challenges for some munis, particularly in healthcare and higher education. Among other funding cuts, the act could replace a flat 1.4% tax on college and university endowment investment earnings with a more financially burdensome tiered tax of up to 8%. The bill is also targeting Medicaid benefits, including the reduction of caps on provider taxes among states. Lower federal funding of Medicaid in many states could reduce hospital revenues in the end, especially those that rely mostly on Medicaid patients for income. For most larger issuers, however, these challenges will likely be manageable.
Muni Strategies in an Unsettled Environment
Whether OBBB- or excess supply–related, muni issuers are rarely impacted to the same extent, which makes careful credit analysis and selectivity words to live by. And in an unsettled climate like today’s, staying active and nimble should include considering the following strategies:
Own Municipal Credit—Credit, spanning A-rated, mid-grade and high-yield issuers, still offer compelling yields and attractive credit spreads backed by solid issuer fundamentals. In fact, upgrades have outnumbered downgrades for 17 consecutive quarters now. Most municipalities continue to have record-high reserves and layers of budget flexibility to lean on. As we see it, this underpins the muni market’s ability to not only support local communities but to absorb the numerous federal policy changes under consideration.
Extend Duration—With the yield curve currently steeper at longer maturities, we recommend a longer duration, or sensitivity to interest-rate changes, relative to the benchmark. This is based on our belief that yields will fall as the economy slows and the Fed eventually will resume its rate-cutting cycle.
Pursue a Barbelled Exposure—Given the steeper yield curve, we think investors should take advantage of the long end but also pair longer maturities with short-term bonds in a “barbell” structure. We think a 15- to 20-year maturity range on the long end is appropriate, as these bonds offer both high yields plus roll—the process of bonds rolling down the yield curve as they approach maturity, which raises their prices when the curve is steep. If the curve flattens, which we expect, it would also lift prices for bond owners. A barbell structure isn’t right for all yield environments, but the ability to take advantage of a changing yield curve shape is one reason why staying active has potential to add value.
We expected some of 2025’s pockets of volatility and appreciate that much of the damage to market returns was contained to the three-day period following tariff announcements. Short-term volatility is still in the cards, but the muni market is resilient and has already rallied from its April lows.
Munis have underperformed this year, but given high yields, a steep yield curve, cheap relative values and supportive technicals, we believe they’re poised to perform well during the second half.
- Daryl Clements
- Portfolio Manager