While the broader environment remains favorable for income-focused strategies, the record-breaking pace of issuance, at over $221 billion, is more than 24% higher than at this time last year, which was already a record year.1
This, along with ongoing policy uncertainties, is tempering enthusiasm and creating a headwind for relative performance, especially in the investment grade (IG) segment, which returned -0.12% in tax-exempt IG and 0.81% in taxable during the second quarter.2,3
These returns compare unfavorably to the US Aggregate, which returned 1.21%, and US Treasuries, which returned 0.85% during the same period.4,5 Corporate high yield (HY) also outperformed municipal HY, returning 3.53% compared to -1.44%, respectively.6,7
For investors willing to navigate these crosscurrents, the muni market continues to offer attractive opportunities ...
For investors willing to navigate these crosscurrents, the muni market continues to offer attractive opportunities, especially in IG and HY segments, though selectivity and active management remain paramount.
A constructive, but more complex environment
The tone for Q3 is broadly positive, albeit less exuberant than in prior years. The municipal market continues to benefit from attractive absolute yields, especially in the IG space. For income-focused investors, this poses a rare moment: yields are near the top decile of the past five years when compared to both IG Corporates and Treasuries (Chart 1).
Chart 1. Yield to worst: Munis vs. Corporates vs. Treasuries
And while this relative value has not gone unnoticed, it has yet to fully translate into performance, in part due to the sheer volume of new supply.
Following a record-breaking $500 billion in issuance in 2024, 2025 is on track to eclipse that figure.1 This surge in supply has created a technical headwind, particularly for IG munis, where the market has struggled to absorb the volume without some price concessions. While demand remains healthy, especially from long-term investors, the imbalance has weighed on returns and contributed to underperformance relative to other fixed income sectors.
Factors behind the underperformance
We believe several factors are contributing to the muni market’s muted performance despite its attractive fundamentals:
- A significant amount of capital remains on the sidelines.Investors are grappling with uncertainty surrounding the tax and economic implications of the potential passage of the Big Beautiful Bill. Possible implications include Medicaid funding, education funding, and state and local tax deductions, which have made some investors hesitant to commit capital to the space.
- The market is still adjusting to the implications of tariff policy and the Federal Reserve’s evolving stance.The uncertainty surrounding fiscal and tariff policies has exerted upward pressure on the long end of the yield curve. Additionally, although the Fed has signaled a pause in rate cuts, volatility in the Treasury market has prompted many investors to favor ultrashort strategies, seemingly hiding in low-duration assets until the policy outlook becomes clearer.
Income remains the anchor
Despite these challenges, we believe the case for munis as a potential source of stable, tax-advantaged income remains strong. With yields at historically attractive levels, many investors are embracing a coupon-clipping mindset, focusing less on price appreciation and more on steady income generation. This approach is particularly well-suited to the current environment, where volatility and policy uncertainty are likely to persist throughout the remainder of the year.
Therefore, we believe IG munis offer a strong value proposition. Compared to five years ago, today’s yields are in the 90th percentile, providing a rare opportunity for investors to secure income at elevated levels. While spreads have widened slightly, they remain tight relative to historical norms, indicating that the market still views credit risk as manageable.
High yield: Slowing, but remains strong
The HY muni space continues to offer attractive opportunities, especially in a slow-growth environment. While issuance has increased from its lows, it has not overwhelmed demand for the asset class to date. Credit fundamentals remain resilient, and default activity is still muted.
Interestingly, HY munis look even more attractive when compared in their historical relationship to HY Corporates.
Spreads between HY and IG munis have widened slightly, creating opportunities for discerning investors. Interestingly, HY munis look even more attractive when compared in their historical relationship to HY Corporates (Chart 2), suggesting that the muni market may underappreciate the relative value in this segment.
Chart 2. Municipal high yield vs. Corporate high yield
Sector views: Local over state, and housing over higher ed
We remain in favor of local issuers over state-level credits. Local governments tend to depend more on property taxes, which are generally more stable during a slowing economy than sales or income taxes. This provides them with a more reliable source of revenue, enabling them to withstand economic downturns more effectively.
Housing
Within sectors, housing stands out as an underappreciated opportunity.
There has been a noticeable increase in issuance, primarily from higher-quality credits, ranging from high AA to low BBB, offering attractive yields relative to risk. Housing bonds can come in several different flavors, but much of the recent issuance has come in the form of securitized structures backed by mortgage loans underwritten using the same guidelines as Fannie Mae and Freddie Mac. The strong underwriting standards help ensure the reliability of cash flows. We believe issuance will remain robust given the ongoing nationwide housing shortages. Furthermore, the combination of strong credit quality and a clear social need makes this sector particularly compelling.
Hospitals and higher education, by contrast, present a more mixed picture. While there has been a surge in issuance from both sectors, the underlying fundamentals are diverging. In higher education, demographic headwinds and enrollment pressures continue to weigh on the outlook. We remain cautious here, especially for smaller, standalone institutions.
Hospitals
Hospitals are more complex. Larger systems with economies of scale are better equipped to handle potential cuts to Medicaid funding under the new tax legislation. These issuers might even gain from consolidation trends and operational efficiencies. However, standalone hospitals – especially those in rural or underserved areas – may face greater risks and need closer scrutiny.
Charter schools
Charter schools, particularly those in areas of higher need, continue to offer niche opportunities. While not without risk, these credits can provide attractive yields for investors willing to do the credit work. However, as always, selectivity is key.
Corporate-backed municipal bonds
While not typically what comes to mind when considering munis, we believe that corporate-backed issuers tend to offer value in a few key areas. Large, IG sponsors that often support these bonds, tend to have shorter duration, and may offer enhanced spreads without taking on undue credit risk.
Positioning for Q3 and beyond
Looking ahead, we believe the muni market will continue to offer attractive opportunities for income-oriented investors, but the path forward will require careful navigation. The record pace of issuance is unlikely to abate in the near term, and policy uncertainty – both fiscal and monetary – will continue to be a source of volatility.
In this environment, we favor an income-driven approach: combining ultrashort positions to manage interest rate risk with longer-duration holdings to capture yield.
Active management will be essential, not only to identify relative value across sectors and maturities but also to manage liquidity and credit risk in a market that is still adjusting to a new equilibrium.
For investors with a longer time horizon and a tolerance for volatility, we believe this may be one of the most attractive entry points into the muni market in years.
For investors with a longer time horizon and a tolerance for volatility, we believe this may be one of the most attractive entry points into the muni market in years. The combination of elevated yields, improving credit fundamentals, and a supportive demand backdrop creates a compelling case for re-engagement, especially as sidelined capital begins to return.
Final thoughts
We believe the third quarter of 2025 is shaping up to be a period of transition for the muni market. While the environment remains broadly constructive, the challenges of record supply, policy uncertainty, and shifting investor sentiment require a more nuanced approach. For those willing to embrace complexity and focus on fundamentals, the muni market continues to offer meaningful opportunities to generate tax-advantaged income and preserve capital in a volatile world.
Endnotes
1 "US Municipal Bonds Statistics." SIFMA, June 2025. https://www.sifma.org/resources/research/statistics/us-municipal-bonds-statistics/.
2 Bloomberg Municipal Bond Index, June 2025.
3 Bloomberg Municipal Index Taxable Bonds, June 2025.
4 Bloomberg U.S. Aggregate Index, June 2025.
5 Bloomberg U.S. Treasury Index, June 2025.
6 Bloomberg U.S. Corporate High Yield Bond Index, June 2025.
7 Bloomberg Municipal Bond High Yield (Non-Investment-Grade), June 2025.
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.
Indexes are unmanaged and have been provided for illustrative purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
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).
AA-020725-195624-1