Municipal bonds: Navigating opportunity in a Fed easing cycle?

Muni markets are entering Q4 with renewed momentum, following a period of robust issuance and shifting investor sentiment. Issuance is on track to exceed last year's record supply levels, initially driven by uncertainty surrounding tax policies and sustained through rising infrastructure costs due to inflation.

While this surge in supply has acted as a headwind for performance through much of 2025, recent weeks have shown a notable shift. Munis have begun to rebound, supported by improving fund flows and a more accommodative view on the trajectory of Fed policy (Figure 1).

As we move into year-end, we expect issuance to remain elevated through the first half of Q4 before moderating in the latter weeks. Fund flows have also strengthened, with 26 weeks of inflows against 11 weeks of outflows year to date in 2025.

While not as strong as 2024's 43 weeks of inflows, it stands in sharp contrast over 2023, which saw just 12 weeks of inflows. The steadier tone this year suggests investors are gradually repositioning ahead of further rate cuts, providing a constructive technical backdrop for the remainder of the year.

Summer tailwinds arrive just in time for fall

The Fed’s recent 25 basis point (bps) rate cut marks a pivotal shift in monetary policy, signaling the start of what could be a broader easing cycle. For muni investors, we believe this transition presents a timely opportunity to reassess portfolio positioning.

Historically, munis have performed well in the months following rate cuts, offering attractive after-tax returns and relative stability compared to other fixed income assets.

Recent performance data reinforces this trend. In Q3 2025, investment grade (IG) munis returned 3.00% in the tax-exempt segment and 2.51% in the taxable segment, outpacing the US Aggregate (2.03%) and US Treasuries (1.51%).^1,2,3 Conversely, within the high yield (HY) segment, corporate bonds outperformed munis, with corporate HY returning 2.54% vs. 1.63% for muni HY.^4,5,6

As we enter the final quarter of 2025, we believe the macro backdrop – slowing inflation, moderating growth, and a more dovish Fed – sets the stage for munis to play a central role in income-oriented portfolios.

Cuts following an extended pause

The quiet setup for muni strength

We look at the performance for the 12 months after periods when the Fed held rates steady for an extended period followed by cuts (i.e., 2023, 2007 and 1998). We see strong performance for short-term munis on a tax equivalent basis, delivering excess income over Treasuries.

The 2023 hold cycle, which lasted from July 2023 to September 2024, is a recent example (Table 1).

Following the first cut, 1-year munis returned 3.37%, or 5.34% on a tax-equivalent basis. US Treasury bills (T-bills), by comparison, returned 4.50%. While Treasuries offered slightly higher nominal returns, munis provided superior after-tax income for investors in higher brackets.

Similar trends were observed in earlier cycles. In the 1998 hold phase, 1-year munis returned 3.44% 5.46% tax-equivalent yield, nearly matching the 4.59% return from Treasury bills (Table 2).

In 2007, munis returned 7.80% tax-equivalent, compared to 3.28% for Treasuries (Table 3).

These results suggest that munis can be a strategic allocation even before monetary policy shifts, particularly for investors looking to take a step out of cash seeking tax-advantaged income.

Munis in cut cycles

A history of outperformance

Historically, munis have delivered competitive returns in the months following a Fed rate cut. Looking back to the previous three easing cycles – specifically in 2001, 2007, and 2019 – IG munis provided steady positive returns averaging 3.54% taxable equivalent yield in the six months following the initial cut.

Investors can potentially capitalize on relatively elevated income rates post-Fed cut as the disparity between short-term munis and short-term Treasury rates grows after the first cut. Also, when adjusted for tax-equivalent yield, those returns averaged 3.89 on a taxable equivalent basis percentage in prior accommodative periods, offering a meaningful advantage for higher tax bracket investors over T-bills.

HY munis also stand out as an outperformer, historically speaking. Despite their higher volatility, high yield munis have shown relatively strong performance, averaging 3.63% total return on a taxable equivalent basis in prior cutting cycles (Table 4).

In contrast, corporate HY averaged 1.01% during those three periods. We believe this performance gap underscores the value of munis not just for their yield, but for their tax efficiency and potential for price appreciation in a declining rate environment.

Yield trends

Munis hold their ground as Treasuries decline

Another compelling reason to consider munis in a Fed easing cycle is their yield behavior relative to Treasuries. In the 12 months following the start of past cut cycles (1995, 2001, 2007, and 2019), 3-month Treasury yields declined steadily from around 4.2% to just over 2.0% (Chart 1). This drop reflects the Fed’s efforts to stimulate the economy through lower borrowing costs.

Short-term muni yields remained elevated and offered relatively elevated levels of income throughout the same period. In some months, muni yields even rose temporarily before stabilizing, providing investors with a cushion against falling rates. This divergence in yield paths reinforces the case for munis as a source of stable, tax-efficient income in a declining rate environment.

For investors in higher tax brackets, we believe munis can offer significantly more income than Treasuries, even when headline yields appear similar.

Positioning for the next phase of the cycle

With the first rate cut now behind us, and potentially three or four more cuts to come by the end of next year, muni investors should consider several strategies to position, such as a barbelled duration curve approach or a blend of high yield and investment grade bonds to lock in elevated income rates for the remainder of 2025 and beyond:

Extend duration selectively

As rates decline, longer-duration bonds tend to benefit from price appreciation. Investors may want to consider extending duration modestly within their muni holdings, particularly in high-quality IG names. This can help lock in attractive levels of income while positioning to take advantage of total return prospects in a more accommodative environment.

Incorporate high yield munis

For those with higher risk tolerance, HY munis offer enhanced income potential and have historically outperformed in the early stages of a cut cycle. Credit selection remains key, but the sector may benefit from stability in fundamentals and a more supportive rate environment.

Prioritize tax-efficient income

Munis continue to offer superior after-tax yields compared to Treasuries, especially for investors in higher tax brackets. As nominal yields compress, the value of tax-exempt income becomes even more pronounced. Investors should evaluate their tax exposure and consider munis as a core component of their income strategy.

Diversify across credit and maturity

A balanced approach – blending IG and HY munis across short and long maturities – can help manage risk while capturing opportunities across the curve. Barbelling may also be effective in navigating rate volatility.

Endnotes

¹ Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD.
² Bloomberg U.S. Aggregate Index, September 2025.
³ Bloomberg U.S. Treasury Index, September 2025.
⁴ Bloomberg U.S. Corporate High Yield Bond Index, September 2025.
⁵ The Bloomberg US Municipal Index is a flagship measure of the US municipal tax-exempt investment grade bond market.
⁶ Bloomberg U.S. Municipal Index, September 2025.
⁷ "Powering growth: data centers impact muni issuers’ risk and reward." Nuveen, April 2025. https://www.nuveen.com/en-us/insights/municipal-bond-investing/data-centers-impact-muni-issuers-risk-and-reward.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.

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).

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