August 2025 review and outlook
Market review
For August, AAA-rated tax-exempt municipal bond performance was positive across the curve. The high-grade tax-exempt yield curve flattened, while the Treasury yield curve steepened. The ratio of AAA-rated tax-exempt municipal yields to US Treasury yields was steady across the short and middle end and slightly tighter on the long end, with municipals underperforming compared to Treasuries at the front end and outperforming on the long end. The yield ratios increased by 2 ratios in five years, was flat in ten years and decreased two ratios in 30 years.
The best performing states were North Dakota, Nebraska and South Dakota. The weakest performers were Wyoming, Mississippi and Vermont. The highest outperforming revenue sectors were Resource Recovery, IDR/PCR and Water Recovery, while the weakest performers were Tobacco, Electric and Transportation. By quality, AAA and A-rated municipals were the strongest performers, followed by AA and BBB-rated municipals, respectively.
The Bloomberg US Aggregate-eligible Taxable Municipal Bond Index generated a total return of 1.24%. Spreads for the taxable municipal index tightened by 3bps and spreads for the credit long index were flat.
Monthly municipal issuance was $51bn, above the average for the month over the last five years. Taxable municipal issuance represented 6% of August’s supply.
Muni fund flows were positive for August, with inflows averaging $1.125bn per week. ETF fund flows were positive for August, with outflows averaging $1.0bn per week.
Outlook
Municipal credit conditions remain solid as we enter an uncertain post-election period. For the state and local tax-backed sectors, the resiliency of credit conditions is supported by very high reserves and cash balances that have accumulated over the last few years. Nevertheless, a number of risk factors remain, including softening economic conditions that could be exacerbated by government policies, persistently high labor expenses, and rising property insurance costs associated with increasing natural disasters and their potential impact on home prices and migration.
We continue to forecast a softening US economy and slight moderating of inflation. The heightened uncertainty surrounding the new Trump administration’s policies, some of which may be inflationary, is likely to keep pressure on longer maturity rates. Municipal yields may follow the trend in Treasuries with the prospect of more yield curve steepening.
From a sector perspective we favor revenues such as public power and water/sewer utilities, which offer stability due to their independent rate setting ability, essentiality, and relatively predictable cash flows. We are generally underweighting sectors that offer less yield premium such as state and local general obligation and pre-refunded bonds. Credit spreads have compressed significantly in recent years and may have room to run further given a solid fundamental credit backdrop and steady demand prospects for municipal bonds.
We continue to see good value in airport and toll road credits due to the recovery of air and vehicular travel respectively to pre-pandemic levels. Mass transit remains challenged due to work-from-home arrangements, although we are seeing some momentum toward returning to office. Healthcare is facing headwinds from rising labor and equipment costs, while higher education is strained by weakening demographic trends and tuition affordability concerns. On balance, we prefer to focus on large, geographically diversified issuers with strong balance sheets, which are able to withstand temporary periods of economic weakness. The increasing frequency and magnitude of natural disasters such as hurricanes, flooding, and wildfires, in combination with strained federal funding for disaster relief, highlights the importance of considering physical climate risks.
In the near term we are targeting duration to be neutral to slightly long versus respective benchmarks. The considerable steepening of the municipal yield curve toward an upward slope has increased the incentive for investors to extend duration and capture attractive incremental yield in the face of Fed easing in the second half of the year. The prospect for higher inflationary impacts from fiscal and tariff policy of the new administration may drive a more bearish steepen environment longer term as long rates could be pressured higher.