Municipal bonds outlook: Poised for the next act?

Lights, camera, allocation! Munis enter the second quarter of 2026 following a meaningful reset. After two years of record issuance weighed on performance, the market is beginning to show signs of stabilization – supported by improving technicals, attractive tax‑equivalent income, and resilient credit fundamentals.

While uncertainty around Federal Reserve (Fed) policy and economic growth persists, we believe the backdrop increasingly favors a more selective and deliberate approach to muni investing.

Setting the stage

In this next act for munis is where we believe conditions are established, not conclusions.

The macro backdrop

Expectations for monetary policy remain an important consideration for muni investors, but the outlook has become less about the certainty of rate cuts and more about navigating an extended period of policy uncertainty. While earlier expectations centered on multiple Fed cuts in the second half of 2026, recent developments suggest a higher bar for near-term easing, particularly as inflation pressures have re-emerged alongside ongoing geopolitical risks.

At the same time, economic activity has remained resilient, supported by capital expenditures, fiscal stimulus, and the wealth effect from equity markets. For muni investors, this combination matters less for near‑term growth forecasts and more for how long income remains elevated, how effectively portfolios can absorb volatility, and where diversification benefits may be most valuable in a choppier market environment. In this setting, munis continue to stand out for their ability to deliver tax‑advantaged income while historically exhibiting lower volatility than many taxable fixed income alternatives.

A market reset

Munis faced meaningful headwinds in 2025, driven largely by two consecutive years of record issuance, totaling roughly $550 billion in the most recent year. That supply weighed on prices and relative performance vs. taxable fixed income as the market worked through a period of absorption. Yet this adjustment also reshaped the opportunity set entering 2026 by lifting starting yields and expanding the range of structures and credits available to investors.

Early 2026 has already brought signs of rebalancing. Investor flows have returned, helping to stabilize technical conditions, while the buyer base continues to evolve as muni exchange-traded funds (ETFs) account for a larger share of demand and separately managed accounts (SMAs) remain a natural fit for tax-aware investors (Chart 1).

Taken together, higher starting yields, renewed inflows, and a broader buyer mix have begun to shift the market away from supply pressure and toward opportunity selection, where structure and security-level decisions carry greater weight.

Where value is emerging

Why now is the time to put down the Playbill^® and pay attention.

Relative value and income

On a tax-equivalent yield basis, investment-grade municipals are yielding north of 5%, a level that compares favorably with corporate bonds of similar quality. This advantage reflects not absolute yield, but also the embedded tax efficiency of the asset class and its historically favorable credit characteristics.

For income-focused investors, we believe munis offer a combination that is increasingly difficult to replicate elsewhere in fixed income: attractive after-tax income paired with diversification benefits that have historically helped dampen portfolio volatility during periods of market stress. In this context, relative value is less about timing a turn in rates and more about positioning for income and stability in a less predictable market.

Positioning across the curve and credit spectrum

Yield curve dynamics: Positioning with purpose

The municipal yield curve remains inverted across much of the front and intermediate maturities, shaping how investors are approaching portfolio construction in an environment where income certainty is increasingly valued. Demand has remained strongest in the one-to-five-year segment, driven largely by SMA laddering strategies and a preference for capturing yield without extending too far out the curve. Further out, modest steepness persists, offering longer-maturity bonds a role as diversifiers should volatility rise or growth expectations soften.

Within this framework, a barbell style approach – pairing short-term exposure for income and liquidity with longer maturities for potential price appreciation – has gained traction as a way to balance income generation, volatility management, and total return potential.

In practice, this reflects less a directional rate call and more an effort to balance carry today with optionality should policy turn more accommodative.

Short-term municipals: Income with flexibility

Short-term munis play an increasingly important role in the current outlook, particularly for investors seeking income stability amid policy uncertainty. A key cornerstone of this segment is the variable rate demand note market, where securities reset frequently and typically trade at par, supported by bank liquidity facilities that contribute to structural stability.

Historically, short-term munis have delivered strong tax equivalent income compared with rolling Treasury bills, while also benefiting from a more measured adjustment in income levels during periods of market volatility (Chart 2).

In an environment where front-end rates may remain higher for longer, these characteristics reinforce the appeal of short-term munis as a way to possibly generate tax-advantaged income without taking on excessive duration risk.

High yield municipals: Opportunity with dispersion

High yield (HY) munis currently trade at historically wide spreads relative to HY corporates on a tax‑equivalent basis, creating meaningful income opportunities alongside clear differentiation across sectors (Chart 3).

Recent performance has reflected that unevenness, with pressure in areas such as tobacco bonds, where declining shipment volumes and lower inflation linked revenue adjustments have weighed on results, as well as select project finance exposures where revenue has lagged expectations.

Despite these pockets of weakness, broader municipal credit fundamentals remain stable, and for investors willing to take selective credit risk, HY munis offer both income and total return potential, particularly when spreads revert toward long-term averages.

In HY munis, broad market direction plays more of a supporting role. What drives outcomes is the credit work of understanding the revenue pledge, the debt structure, and how a deal performs under stress. This is the part of the market where deep knowledge of individual credits compounds into real performance differentiation over time.

Multi-family housing continues to benefit from a structural undersupply of affordable units and bipartisan legislative tailwinds, remaining as one of our highest conviction sectors. HY airports have tightened meaningfully on the back of post-pandemic travel demand, but we remain disciplined about entry points, and any weakness from travel disruptions or rising fuel costs tied to the ongoing situation in the Strait of Hormuz could be an opportunity to increase exposure.

HY toll road credits offer essential service revenue streams to hedge against inflation that we find similarly attractive on any rate-driven cheapening. Energy-adjacent credits, including pre-paid gas and corporate-backed bonds, offer attractive intermediate yields, and with strong demand for energy unlikely to abate anytime soon, we believe there’s further room for outperformance despite record levels of supply in the sector.

Other opportunities we find are in select land-secured, special tax deals where location quality, experienced sponsors, and sound collateral packages can separate winners from the rest. We favor rental continuing care retirement communities, where a simpler revenue model and aging demographic provide a more compelling risk-reward than traditional entrance fee structures. Hospitals demonstrating real operational improvements and select charter school systems in states with favorable operating environments round out the opportunity set.

Credit fundamentals

A stable anchor

Municipal credit enters the second quarter of 2026 from a position of balance rather than stress. Default rates remain materially lower than those observed in corporate credit, while recovery rates have historically been higher, often supported by the essential‑service nature of many municipal issuers. At the same time, state and local governments continue to benefit from elevated rainy‑day reserves, providing flexibility as economic conditions evolve.

This stability is not occurring in isolation. Tax revenues – including income, sales, and property taxes – have generally held up, supported by economic activity and equity market performance. While fiscal conditions continue to vary by issuer and region, the broader municipal credit landscape remains constructive. Taken together, these dynamics suggest that the current environment supports selective risk‑taking rather than defensive positioning, reinforcing the role of credit research and differentiation as investors navigate the next phase of the cycle.

Why sector and geographic selectivity matters

Municipal outcomes are inherently local, reinforcing the importance of bottom-up analysis. Demographic trends continue to support sectors such as healthcare and continuing care retirement communities as the population ages, while geographic factors – including migration patterns, pension obligations, and fiscal management – create dispersion across states and municipalities.

At the same time, climate and infrastructure considerations, such as flood and wildfire risks, are increasingly incorporated into credit analysis alongside investments aimed at resilience and mitigation.

In this environment, selectivity is less about avoiding risk altogether and more understanding where risk is being priced appropriately. That perspective underscores the value of active, research-driven municipal investing, particularly when market conditions present both opportunity and differentiation at the same time.

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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