Market Commentary

• We believe municipal bonds currently offer investors an attractive entry point as risks to the elimination of the municipal-bond tax exemption are receding and income potential has increased.
• With rates moving higher, now may be a good time for income-oriented investors to consider locking in attractive yields.

While fixed-income securities may not be as entertaining as many other investments, there is one area of the bond market that is quietly showcasing a triple threat of relative stability, attractive yields, and tax advantages. We believe municipal bonds – or munis – currently offer a compelling case for investors seeking attractive opportunities with more stability than the wild swings sometimes seen in the stock market.

Municipal bonds are debt instruments issued by state and local governments to fund general obligations and critical projects such as schools, roads, and water systems. Tax-conscious investors have enjoyed owning these securities for their exemption from federal income tax, and, in many cases, from state taxes if they buy bonds from their home state. While there has been some speculation that Congress may try to remove the municipal tax exemption as part of the spending reconciliation bill making its way through Washington, we think the possibility of such an outcome is extremely low.

Municipal bonds have a long history of solid credit stability relative to corporate bonds. Because they are backed by the taxing power of state and local governments, municipal bonds have a track record of low default rates. Investment-rated general obligation bonds and essential-service revenue bonds have a 5-year cumulative historical default rate of less than 0.05%, going back to the 1970s.¹ Compare this with corporate bonds, where defaults are more frequent and downgrades can feel like navigating a minefield at times, and you can see that the relatively smooth and more dependable ride munis have historically offered investors is attractive.

Finally, the spike in U.S. Treasury yields this year has ushered in higher yields across the bond market, another reason income-oriented investors may want to consider taking a close look at municipal securities. These higher yields were a big reason we upgraded our guidance on municipal bonds on May 15, 2025, to favorable from neutral. As of May 21, 2025, 10-year AA-rated munis are yielding around 3.5%, a significant increase over the 1% yields of a few years back. Valuations have become more attractive while credit fundamentals remain solid. Add in positive news about retaining the tax exemption, and we think municipal securities are worth getting excited about.

That said, the municipal bond market has its nuances. Interest rates and bond market prices tend to move in opposite directions. We expect that interest rates will be flat to lower in the year ahead; however, it could be a volatile path to get there. While buy-and-hold investors can expect to receive tax-exempt income on a predictable path to maturity, investors should expect to see the market prices of those securities fluctuate. This is especially true for longer dated maturities, which tend to be the most sensitive to interest rate moves. We also suggest that investors investing in municipal bonds stick to higher-rated general obligation and essential-service revenue securities for better credit stability. Investors should work with their investment professional to navigate the nuances of the municipal market.

¹ US municipal bond default and recovery rates, 1970-2023. Moody’s, October 24, 2024.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation, and other risks. Prices tend to be inversely affected by changes in interest rates. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

Bond rating firms, such as Moody’s, Standard & Poor's, and Fitch, use different designations consisting of upper- and lower-case letters 'A' and 'B' to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds".

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