Municipal bonds | Insight Investment

Market review

For June, AAA-rated tax-exempt municipal bonds posted positive returns across the curve with the 6 to 8-year and 4 to 6-year indices performing the best. The high-grade tax-exempt yield curve steepened, while the Treasury yield curve steepened slightly. The ratio of AAA-rated tax-exempt municipal yields to US Treasury yields was tighter for five years but wider for ten and thirty years, with municipals underperforming compared to Treasuries. The yield ratios decreased by one ratio in five years, increased two ratios in 10 years and increased three ratios in thirty years.

The best performing states/territories were Guam, Arkansas and Connecticut. The weakest performers were Vermont, Oklahoma and Wyoming. The highest outperforming revenue sectors were IDR/PCR, Tobacco and Special Tax, while the weakest performers were Housing, Hospital and Water & Sewer. By quality, BBB-rated municipals were the strongest performers, followed by A, AA and AAA-rated municipals, respectively. 

The US Agg-eligible taxable municipal index generated a total return of 2.43%. Spreads for the taxable municipal index tightened by 4bp and spreads for the credit long index tightened by 6bp.

Monthly municipal issuance was $53bn, above the average for the month over the past 5 years. Taxable municipal issuance represented 9% of June’s supply.

Muni fund flows were positive for June, with inflows averaging $275m per week. ETF fund flows were positive for June, with inflows averaging $848m per week.

Quaterly market environment

The municipal bond market experienced elevated volatility relative to Treasuries in April, as a tariff-induced bond selloff coincided with a seasonally weak period for supply and demand. May and June conditions improved as municipal bond performance recovered in line with Treasuries, supported by seasonally strong demand. For the second quarter, municipal bonds overall underperformed other fixed income markets, in part due to record-setting new issue supply and muted mutual fund demand. During 2Q25, total issuance topped $160bn, up 13% compared to 2Q24. Year-to-date taxable municipal issuance held steady at approximately $18bn compared to the first quarters of last year. Demand from retail investors was mixed as municipal open-ended mutual funds experienced $2.6bn in net outflows (per ICI) compared to ETFs which attracted $8.8bn of inflows during 2Q25.

During the second quarter, the AAA municipal yield curve continued to steepen as short-term yields decreased, while intermediate and longer maturity bond yields increased. Municipal AAA yields decreased 5 to 15 basis points (bps) for two-to-five maturities, while yields increased by 1 to 26bp for 10- to- 30-year maturities. The 2-year and 30-year AAA municipal curve steepened 31bp in 2Q25 to 188bp. Similarly, US Treasury curve steepened, with yields from 2- to- 5-year maturities decreasing 13bp to 16bp, while yields from 10-to-30 years increased 6bp to 25bp. The Muni-Treasury ratio, a key gauge of relative value, cheapened slightly during 2Q25 across all maturity tenors. The 10-year AAA Muni-to-Treasury ratio increased slightly to 76%, while the 30-year ratio cheapened slightly to 95% from 92%, still looking the cheapest compared to historical levels from the past few years.  During the recent quarter, longer duration municipal bonds underperformed their shorter counterparts, reflected in the Bloomberg Municipal Long Index return of -1.94%, compared to the Bloomberg Municipal 3-year and 10-year Index returns of +1.05% and +0.78% respectively.

From a quality perspective during 2Q25, the lower-rated segments delivered relatively weaker performance, reflected by the Bloomberg Municipal BBB & A Index return of -0.64% and -0.24% respectively, underperforming the Bloomberg Municipal AAA & AA Index returns of -0.09% and -0.04% respectively. From a sector perspective, the revenue sector underperformed general obligation (GO) bonds. Tobacco, housing, and industrials sub-sectors remained to be the outperformers during the quarter, while hospital, education, and water & sewer sub-sectors were generally weaker performers. Credit spreads continued to widen during 2Q25 as rate volatility, macro-economic, and tax policy uncertainty was heightened. The Bloomberg Municipal High-yield Index returned -1.14% during 2Q25, underperforming the investment-grade Bloomberg Municipal index, which returned -0.12%. The Bloomberg Taxable Municipal Index returned +0.81% during the second quarter, compared to the Bloomberg US Treasury Index return of +0.85% and the Bloomberg U.S. Corporate Index return of +1.82%.

Municipal credit conditions remain solid, supported by very high reserves and cash balances that have accumulated over the last few years. A number of executive actions taken by the Trump Administration, if allowed to stand, could have negative credit implications across large segments of public finance. Tariffs, federal job cuts, and the mass deportation of illegal immigrants are likely to slow economic growth, which could have a negative impact on income and sales tax receipts. At the same time, cuts in federal spending in areas such as Medicaid, “green” infrastructure initiatives, and federal disaster relief could pressure state/local budgets.

The US economy has moved into a “falling” growth regime led by recent tariff policy uncertainty which should drive a softer economic backdrop for 2H25. Inflation data over recent months has re-affirmed the slow, but gradual disinflation regime that we have been in for several years. We expect the Fed to remain patient and resume easing by year-end in response to moderating growth and a weaker labor market. Muni yields should follow Treasuries with the prospect of a further steepening yield curve led by the pull of expected Fed rate cuts on the short-end.

Outlook

We expect elevated financial market volatility to continue amid ongoing uncertainty around tariffs, geopolitical alliances, and overall policy change prospects tied to federal funding, among others. We remain vigilant with maintaining well diversified, high-quality portfolios consisting of solid fundamental credits that we believe are well-positioned to withstand pressures from potential policy changes in Washington DC. We also would view any market dislocation stemming from federal policy uncertainty as a potential buying opportunity.

Uncertain changes to federal policy could drive heightened volatility in credit conditions as we move through 2025. We believe a more cautious approach to credit selection would be prudent, with an increased emphasis on balance sheet strength, liquidity and operating flexibility. Essential service sectors, including public power and water/sewer, remain relatively safe investments due to their predictable and stable cashflows through economic cycles. Healthcare is facing potential headwinds stemming from potential cuts to Medicaid, which could have an outsized negative impact on smaller, rural hospitals. Threatened cuts to federal grants and potential changes to endowment tax rates are driving negative headlines among many of the higher rated colleges and universities, yet we believe these institutions have substantial resources to withstand the cuts and would view any spread widening as a buying opportunity. We continue to see value in the transportation sectors although airports with heavy reliance on international travel are likely to see some softening in demand.

Our duration posture is targeted neutral to modestly long versus respective benchmarks. The recent backup in municipal yields along with yield curve steepening has made the current environment more attractive for modest duration extension. The prospect for transitory impacts of higher inflation from fiscal and tariff policy from the new administration along with the Fed’s dovish bias may keep the slope of the curve elevated and rangebound in the near term.