Crosswinds: Strong Fundamentals, but Threats to Tax Exemption
We expect some of the record $7 trillion of cash on the sidelines to begin returning to fixed income—munis included—as cash rates continue to fall. And there are additional reasons for muni investor optimism, starting with solid fundamentals for most bond issuers. Tax revenues are down slightly from record highs, but state balance sheets remain strong. In fact, the median rainy-day cash balance now represents a record 14.4% of states’ general funds.
Take California. The world’s fifth largest economy avoided a record projected deficit in 2024 through effective belt tightening and reserve management. Moreover, Moody’s Investors Service removed the state’s negative rating outlook. Even today’s devasting wildfires, while a major test, have demonstrated California’s strength. Municipalities have historically shown resilience in the face of major natural disasters.
Meanwhile, rekindled talk in Washington over eliminating the tax-exempt status of muni bonds has raised investor concerns. We don’t expect a wholesale removal; lawmakers know that would impede supply and could necessitate raising taxes to fund projects in their jurisdictions.
A more likely relevant outcome of the election is the extension of the Tax Cuts and Jobs Act. The law includes a $10,000 cap on state and local tax deductions, which has been a key driver of muni demand in states with high income taxes.
Muni Strategies for 2025
From our perspective, this is an opportune time for muni investors to get ahead of rising demand, falling yields and a steepening yield curve.
With that in mind, consider these strategies to get the most out of today’s environment:
Extend your duration target. Lengthening a portfolio’s duration, or sensitivity to interest-rate changes, can help take advantage of falling yields. If yields head lower in 2025 as we expect, longer-duration munis would experience greater price appreciation while also providing steady income for longer. If we’re wrong and yields rise, they’d need to rise significantly to completely erode bonds’ current income cushion. Furthermore, the yield on cash has fallen and the yield on longer-maturity muni bonds has increased, which means investors now receive additional yield for extending duration.
Consider a barbell maturity structure. In 2024, a barbell maturity structure outperformed other maturity structures as the yield curve normalized. It’s still an attractive approach today. A modified barbell structure, which combines short- and long-maturity bonds with select intermediate bonds, could be attractive in 2025, helping investors capture yield and rolldown. Overall, active curve management and opportunistically changing maturity structures will be key.
Look to muni credit. Credit—non-investment grade, BBB- and A-rated bonds—has offered significantly more yield than higher-rated bonds. Credit spreads remain tighter compared to 2024, and while we don’t expect substantial further tightening, current high yields and continued demand for income strongly suggest to us that credit may outperform again in 2025.
Stay flexible. Because relative after-tax yields fluctuate, investors should keep an eye on the relationship between high-grade municipals and US Treasuries. Munis have cheapened recently compared to US Treasuries, so they remain relatively attractive. But investors should be prepared to lean into Treasuries as relative yields change.
In fact, we believe that flexibility in general is key to generating stronger returns. Our research shows that, historically, active municipal bond strategies have outperformed passive approaches 98% of the time over rolling three-year periods and 89% over two-year periods.
Current conditions remain largely favorable for munis, in our view. Municipalities continue to benefit from a relatively strong economic backdrop, and we think that’s unlikely to change. Indeed, we think that today’s high yields, along with expectations of continued rate cuts and a steeper yield curve, make for a timely opportunity for active municipal bond investors who adopt flexible strategies for navigating headwinds and harnessing tailwinds.