Tax-sensitive investors capitalize on municipal bonds

Municipal bonds currently offer tax-sensitive investors compelling return opportunities. Tax-equivalent yields are near the upper end of the last 20 years due to elevated policy interest rates and reasonable valuations. High-income investors in states with meaningful state-level income tax rates may further benefit from state and federal tax exemptions for certain municipal bonds. Current opportunities in municipal bonds hinge on three key factors: favorable yields, meaningful tax-exemptions and solid issuer fundamentals.

Municipal bond yields establish favorable return opportunities

Bond yields play a foundational role in determining future bond returns. This is especially true for bonds with investment grade credit ratings, since credit defaults tend to be low. Fluctuations in yields can temporarily cause swings in bond prices, but over time buy-and-hold investors can expect returns to closely track starting yields.

Two factors contribute to compelling municipal bond yields. First, elevated Treasury yields establish income opportunities across many parts of the bond market. Second, high municipal bond issuance improved yield opportunities specifically in municipal bonds. Municipal bond issuers are on pace for the largest year of new municipal bond supply on record in 2025 which put upward pressure on yields. This supply headwind creates opportunities for investors to purchase bonds at favorable yields.

In the bond market, municipal investors often consider a bond’s tax-equivalent yield as an important measure. This allows investors to compare municipal yields to other bond yields that do not receive a tax benefit. “Currently, investment grade municipals offer approximately 2.2% more yield than Treasury bonds on a tax-equivalent basis, which is above long-term average,” says Bill Merz, head of capital market research for U.S. Bank Asset Management Group. This assumes the top federal income tax bracket to calculate tax-equivalent yields. Municipal bond valuations are reasonable based on their extra tax-equivalent yields over Treasuries and make for compelling income opportunities relative to other assets like corporate bonds that have somewhat elevated valuations.

Municipal bonds’ tax-exemption magnifies the benefit of generating extra income through allocations to longer-term and lower-quality bonds. Over the last five years, high yield municipal bond yields have exceeded investment grade municipal bonds by 3.5% on average. Similarly, longer-term municipal bond yields yielded 0.7% more on average. Accordingly, maintaining a slight bias towards longer-term and lower-quality municipal bonds tends to improve return opportunities. However, primarily allocating to core investment grade municipal bonds remains important because longer-term and lower-quality municipal bonds have additional risks. Longer-term municipal bond prices tend to be sensitive to yield changes, since investors lock in income for many years, and investor sentiment shifts can cause changes in high yield municipal bond prices.  

Tax advantages of municipal bonds

Investors in high tax states may have even better opportunities in municipals. For example, residents of California who own California municipal bonds may be exempt from the 13.3% state-level income tax rate on municipal bond income, in addition to income from these bonds being exempt from federal income tax. This double exemption magnifies the already compelling tax-equivalent yield for residents of certain states.

Municipal bonds exhibit strong credit fundamentals

Municipal bond credit fundamentals remain sound based on credit rating agency actions and state-level finances. Both provide reassurance that well-diversified high quality municipal bond portfolios supported by active credit research and monitoring should exhibit low credit losses in the future, consistent with historical precedent. Active credit research involves investment specialists reviewing individual bonds to ensure ample compensation for the risk of nonpayment.

State level general fund balances, which reflect differences between state revenues and expenditures, increased fourfold between 2019 and 2024, on average. The same can be said for the median state cash balance relative to expenses. Excess cash also contributed to steady growth in rainy day funds among the states. Rainy day funds refer to surplus revenue that has been set aside for budget deficits and unexpected financial needs. Since 2010, the median state rainy day fund rose from eight days’ worth of typical expenditures to 49 days’ worth of expenditures in 2023.

Credit rating agencies, like Moody’s, review thousands of municipal bonds. Rating changes over time indicate a trend of more upgrades relative to downgrades, referred to as ratings drift. According to Merz, “Municipal ratings drift has been improving since the Covid pandemic and reflects improving financial positions for many municipal bond issuers.” Municipal bond ratings are also generally more stable than the larger rating fluctuations for corporate bonds which are more sensitive to economic cycles.

“Compelling yields, reasonable valuations, potential tax benefits and strong credit fundamentals translate to municipal bond opportunities for tax-sensitive investors in current markets,” notes Merz. 

Talk with your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.