Municipal bonds: A whole new level

For much of the past several years, municipal bond (muni) investors have focused on what might happen next. Would inflation continue to moderate? Would the Federal Reserve (Fed) begin cutting interest rates? Would market technicals improve following a historic wave of issuance?

As 2026 draws to a close, the conversation has evolved. Treasury yields have risen to levels not seen since 2007, reshaping the fixed income landscape and giving investors access to income levels that would have seemed unlikely just a few years ago.¹

Against that backdrop, munis face a different kind of test. The question is no longer whether the asset class can benefit from lower rates or more favorable technical conditions. Instead, investors are asking whether municipals continue to offer a compelling value proposition when higher yields are available across fixed income markets.

We believe that answer is yes.

Elevated absolute yields, attractive tax-equivalent income, resilient credit fundamentals, and selective opportunities across both investment-grade (IG) and high-yield (HY) municipals continue to support the asset class. While Fed policy remains an important consideration, we believe success in today's market will depend less on anticipating policy shifts and more on identifying relative value opportunities through disciplined security selection and thoughtful portfolio construction.

Setting the stage

The new rate reality

Rising Treasury yields have changed the conversation across fixed income. Markets continue to grapple with persistent inflation concerns, elevated term premiums, and higher borrowing costs at a time when government financing needs remain substantial. While investors spent much of the past two years debating when rates might fall, today's more important question may be what happens if rates remain elevated for longer than expected.

For municipal investors, that distinction matters. Higher benchmark yields have weighed on bond prices, but they have also increased available income and expanded the opportunity set across the market. In our view, the investment case for municipals no longer depends on a specific interest rate outcome. Instead, today's yield environment offers investors the opportunity to generate attractive income while maintaining exposure to an asset class that has historically demonstrated resilient credit quality and diversification benefits.

Income in context

Looking beyond headline yields

In today's market, headline yields tell only part of the story.

While Treasury yields have risen sharply, we continue to believe municipals continue to offer compelling after-tax income for many investors. Higher absolute yields have amplified the value of the municipal tax exemption, creating attractive opportunities for investors seeking tax-efficient income.

Current market levels place IG municipals near 7.45% on a taxable-equivalent basis, while HY municipals approach 9.72%.^2,3 For investors in higher tax brackets, we believe those income levels compare favorably with many taxable fixed income alternatives.

Short-term municipals provide one example of how today's relative-value opportunity extends beyond headline yields. On a taxable-equivalent basis, their yield advantage over three-month Treasury bills (T-bills) recently stood at approximately 119 basis points (bps), compared with a five-year median of just 3 bps.⁴ The SIFMA Municipal Swap Index recently yielded approximately 5.35%, compared with approximately 4.16% for three-month T-bills (Chart 1).

Importantly, investors no longer need significant spread tightening or substantial Treasury rallies to create a compelling return case. Simply earning today's income stream may be enough.

The current spread highlights how attractive the front end of the municipal market appears relative to historical norms and reinforces the broader case for tax-efficient income in today's market. If rates decline, investors may benefit from price appreciation. If rates remain elevated, reinvestment opportunities could continue supporting portfolio income. In either scenario, starting yields matter, and today's yield environment offers investors opportunities that have been largely absent for much of the past two decades.

Technicals

Supply meets potential opportunity

Municipal issuance remains elevated. At approximately $432 billion year-to-date, issuance is running roughly 8% ahead of last year's record-setting pace.⁵ While that supply has created periodic pressure across the market, it has also expanded the opportunity set available to investors.

Near-term technical conditions remain somewhat challenged. Elevated issuance, seasonal weakness, tax-loss harvesting activity, and occasional fund outflows have created temporary pressure on municipal prices. Volatility may remain elevated over the coming weeks as investors continue adjusting to a higher-rate environment.

However, these same pressures are helping create attractive entry points for long-term investors.

Importantly, the long-term demand picture remains constructive. Fed Flow of Funds data continues to show growth in household, mutual fund, and exchange-traded funds (ETFs) ownership of munis, while institutional ownership has steadily declined as a percentage of the market. Individual investors increasingly represent the dominant source of demand, and ETF participation continues to expand.

Historically, attractive yields have encouraged capital back into the municipal market. We believe current technical weakness is more likely to create opportunities than signal deterioration in underlying fundamentals.

Credit fundamentals

Resilience under scrutiny

Credit fundamentals across much of the municipal market remain broadly resilient, but higher rates and slower economic growth are creating greater differentiation between issuers. In this environment, we believe credit selection matters more than ever.

Tax receipts remain healthy, with total collections tracking approximately 7% ahead of the prior year.⁵ At the same time, municipal defaults remain low relative to what was already a benign distressed environment in 2025.

While the broad backdrop remains supportive, we believe opportunities are increasingly emerging at the following sector levels:

High yield

Income with greater differentiation

HY municipals may offer another source of elevated tax-adjusted income, although issuer and sector selection remain particularly important. Their taxable-equivalent yield spread over US corporate HY recently stood at approximately 163 bps, compared with a five-year median of approximately 101 bps (Chart 2).

Investment grade

The case doesn't require a catalyst

The broadest opportunity, in our view, remains IG municipals.

Higher benchmark yields have improved both absolute and tax-adjusted income, while credit fundamentals remain broadly resilient. On a taxable-equivalent basis, IG municipals currently offer approximately 199 bps of yield advantage relative to the Bloomberg US Aggregate Bond Index, compared with a five-year median of approximately 106 bps (Chart 3).

We believe investors can earn attractive income without relying on spread compression, Fed cuts, or a meaningful rally in Treasury markets.

IG municipals continue to offer a combination of tax-efficient income, high credit quality, and potential upside should rates eventually decline. If rates remain elevated, investors can continue collecting income at levels that have been unavailable for much of the past two decades.

Endnotes

¹ "Bond Market Flashes a Warning Not Seen Since 2007." Yahoo Finance, September 2026. ² Bloomberg US Municipal Bond Index, September 2026. Taxable-equivalent yield assumes a 37% federal tax rate. ³ Bloomberg Municipal High Yield Index, September 2026. Note: Taxable-equivalent yield assumes a 37% federal tax rate. ⁴ Bloomberg, SIFMA Municipal Swap Index Yield (MUNIPSA Index), 3-Month U.S. Treasury Bill Yield (GB3 Govt), September 2021 to September 2026. Note: Taxable-equivalent yields assume a 37% federal tax rate. Current spread: 119 bps; five-year median spread: 3 bps. ⁵ JP Morgan Research, September 2026. ⁶ "US Tax Revenue Statistics 2026." Collections, Sources & Key Facts. The Global Statistics, September 2026. ⁷ Bloomberg, September 2026.

Important information

Past performance is not an indication of future results.
Diversification does not ensure a profit or protect against a loss in a declining market.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.
Indexes are unmanaged and have been provided for illustrative purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
The tax implications of tax management techniques, including those aimed at harvesting tax losses, are complex and uncertain, and they may be subject to challenge by the IRS. Please note the following: (i) any discussion of U.S. tax matters contained in this communication cannot be used to avoid tax, penalties, or interest imposed by the IRS or any other taxing authority; (ii) this communication has been written to support the promotion or marketing of the subjects discussed herein; and (iii) you should seek advice tailored to your specific circumstances from an independent tax advisor. Neither Aberdeen nor its affiliates provide tax advice.

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