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Key takeaways

  • Attractive features in today’s municipal bond market offer investors in high tax brackets compelling opportunities.

  • Tax-equivalent yields on municipal bonds are near 20-year highs.

  • This is explained, in part, by elevated policy interest rates and favorable municipal bond valuations.

Municipal bonds currently offer tax-sensitive investors compelling return opportunities. Tax-equivalent yields are near the high end of the last 20 years due to elevated policy interest rates and cheap valuations. Additional upside potential in the municipal bond market may be available to high-income investors in states with high state-level income tax rates, due to certain municipal bonds being exempt from both state and federal tax on interest income.

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

Bill Merz, head of capital market research for U.S. Bank Asset Management Group

Starting yields, or the interest rates bonds currently pay, 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.

Sources: U.S. Bank Asset Management Group Research, Bloomberg, May 31, 1995 – May 8, 2025.

Municipal bond yields, which move in the opposite direction of prices, are near 20-year highs, primarily due to two factors. First, broader interest rates, such as the Federal Funds policy rate, remain elevated. Second, municipal bond valuations are cheaper than the long-term average.

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 2.0% more yield than Treasury bonds on a tax-equivalent basis, which is 0.60% 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.

 

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.

State specific municipal bond indices are used to compute tax equivalent yields which differ from the national municipal index. Tax equivalent yields assume 37% top federal tax bracket plus 3.8% Affordable Care Act tax plus top marginal income tax rate for state-specific municipal bonds. Sources: U.S. Bank Asset Management Group Research, Bloomberg, May 7, 2025.

Future tax rates remain uncertain, but elevated federal deficits may eventually lead to higher tax rates. To help meet projected budget shortfalls, President Donald Trump recently discussed a new, higher top federal income tax bracket for top earners with Mike Johnson, the Speaker of the House of Representatives. On May 9, 2025, President Trump posted on social media that, “Republicans should probably not [increase income tax rates] but I’m OK if they do.” In theory, the higher the income tax rate, the more investors should be willing to pay for municipal bonds exempt from income tax.

 

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 municipal bond specialists reviewing individual issues 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 has also contributed to steadily growing 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 a whopping 46 days’ worth of expenditures in 2023.

Sources: U.S. Bank Asset Management Group Research, Bloomberg; December 31, 2019 - December 31, 2024.

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 drift also exhibits stability relative to larger fluctuations for corporate bonds, which are more sensitive to economic cycles.

“Compelling yields, cheap 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.

Frequently asked questions

A municipal bond is typically a state, city, or county-issued debt security. Government entities issue such bonds to finance major capital projects, such as roads, schools, or public buildings. As is the case with other types of bonds, investors effectively lend money to the municipal bond issuer in exchange for a promise of regular, timely interest payments. Unlike most other bonds, the interest investors earn on municipal bonds is generally exempt from federal income tax. When the municipal bond matures, the issuer repays the principal. Investors can purchase municipal bonds when they are initially issued or buy them on the secondary market.

Municipal bonds function similarly to other types of bonds, with the issuer making regular and timely interest payments to investors. At the municipal bond’s maturity, investors receive back their original investment, or principal. Unlike most other bonds, municipal bond interest is generally exempt from federal taxation. Therefore, municipal bond issuers typically offer lower nominal yields than similar bonds issued by the federal government or other entities. Accounting for the bonds’ tax-exempt status, investors need to assess a municipal bond’s tax-equivalent yield. For an investor in the 24% federal tax bracket, a municipal bond offering a 3% nominal yield exempt from federal income tax would generate income equivalent to the after-tax income of a U.S. government bond yielding 3.95%.

Risk-averse investors, particularly those seeking to generate an income stream, may opt for municipal bonds over other risk assets. Like any fixed-income security, municipal bonds are subject to interest rate risk. In periods when interest rates rise, the market value of a municipal bond may dip below its par value (the initial investment made). Inflation is another risk. During periods of higher inflation, the stable income generated by a municipal bond will result in less purchasing power. It’s also essential to assess an issuer’s credit risk. Credit rating agencies measure the creditworthiness of state and local government entities. This helps assess the likelihood of receiving timely interest payments and a return of principal upon the bond’s maturity.

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