2026 Outlook: Municipal Bonds

In 2026, we think municipal bonds will continue to offer attractive tax-adjusted yields and credit quality should remain stable. In our view, munis can be an attractive investment option for investors in higher tax brackets looking for relatively conservative investment options and we don't expect that to change in the near future.

The key for performance next year will be demand. We expect another year of elevated issuance and if demand doesn't keep pace, total returns for munis may lag other comparable fixed income investments, as they have so far this year. So far, 2025 has been characterized by a record amount of issuance due to concerns about the muni tax exemption being repealed, higher inflation costs resulting in higher infrastructure costs, and other factors. Even though major tax law changes likely won't be an issue in 2026, issuance should remain elevated.

So far in 2025, performance for munis maturing in seven to 10 years outperformed both shorter- and longer-term munis. Regarding credit quality, most credit rungs of the investment-grade muni space performed close to one another but high-yield was the clear laggard. For example, Baa rated munis are up 4.1% year-to-date, equal to AAA rated munis, which are up 4.1% year to date.¹ However, high-yield munis are only up 2.7% year to date. High-yield munis trailed investment-grade munis because some large high-yield issues experienced financial difficulties, which led to large declines for their outstanding bonds and dragged the rest of the index lower.

Yields should continue to remain attractive—especially when factoring in taxes, which is beneficial for investors who are primarily focused on income. For example, the yield-to-worst (the lowest possible yield an investor can receive from a callable bond, barring default) for the Bloomberg Municipal Bond Index, which is a broad index of munis, is 3.6%. Although that's generally lower than many other comparable fixed income alternatives, like Treasuries or investment-grade corporate bonds, it's because the interest income munis pay is usually exempt from federal and potentially state income taxes. If that 3.6% yield were to be fully taxable for an investor in the top tax bracket, which is currently 37% plus the 3.8% Net Investment Income Tax (NIIT), that's the equivalent of a roughly 6.1% yield. This is called the tax-equivalent yield.

Munis aren't just attractive for investors in higher tax brackets—we believe they can also make sense for investors in lower tax brackets. Going back to the 3.6% yield for the broad index, that's the equivalent of 4.7% yield for a fully taxable bond at the 24% tax rate. It's also worth noting that these calculations don't include a state tax. For investors in high-tax states, like California or New York, including a state tax rate will result in an even higher tax-equivalent yield.

In 2026, we expect intermediate- and longer-term muni yields to remain elevated but short-term yields, which are highly correlated to the federal funds rate, are likely to move lower. We believe that the Federal Reserve will continue to cut interest rates but likely at a slow and methodical pace. This should pull down yields for short-term bonds. However, longer-term yields will likely remain elevated.

For most fixed income investors, we suggest targeting a benchmark duration and focusing on higher-rated issuers. This guidance also applies to the muni market. For most muni investors, an average duration of about six years is a good starting point, in our opinion. A good strategy can be a bond ladder. This can help spread the duration risk across the yield curve. For investors who are more tactical and willing to take on some duration risk, we think a barbell strategy may make sense. A barbell strategy combines some short-term bonds with some longer-term bonds while avoiding bonds in the middle part of the curve. However, both strategies come with risks. A risk of both strategies is that if rates rise the prices of the bonds generally will drop, which could result in a loss. This can be more pronounced with a barbell strategy because there's a larger weighting to longer-term bonds and prices of longer-term bonds tend to be more sensitive to changes in interest rates. Additionally, both are strategies that involve investing in bonds, and bonds have certain risks such as default risk and inflation risk.

Currently, the difference in yields between longer-term munis and Treasuries after taxes is higher for longer-term munis than it is for short-term munis. For example, as illustrated in the chart below, an index of two-year AAA rated muni yields 40 basis points more than a two-year Treasury after factoring in taxes. This difference in yields increases to 110 basis points for 20-year munis and is even greater for 30-year munis. A barbell strategy can take advantage of the more attractive yields on the longer end of the curve while also sticking close to a benchmark duration if combined with some short-term bonds. It's worth mentioning that longer-term bonds are much more sensitive to changes in interest rates. If rates rise, prices for longer-term bonds will fall much more than prices for short-term bonds and investors could experience negative total returns.

A key tenet of municipal bonds is their high and stable credit quality and we don't expect that to change in the near future. Many municipal bonds are directly or indirectly backed by stable revenue sources such as income, sales, property, or other taxes or usage fees. These are revenue sources that generally don't fluctuate that much. Partly as a result, most municipal bonds are very high credit quality to begin with. In fact, nearly three out of four bonds in the Bloomberg Municipal Bond Index are either AAA or AA rated, the two highest rungs of investment grade. This is close to the highest proportion going back to early 2009. Generally speaking, higher rated issuers are less prone to missing principal and interest payments and the prices of their bonds tend to be less volatile than lower rated bonds.

At the end of 2019, shortly before COVID-19 pandemic became a global pandemic, roughly 67% of the munis in the index were either AAA or AA rated. That has since risen to 72% as of the end of October 2025. Part of the reason for the improvement in credit quality was because there was a surge in tax revenues in 2021 and 2022. As illustrated in the chart below, tax revenues have increased by more than 20% since the onset of the pandemic. Although the pace of revenue growth has slowed recently, it is still positive and close to the longer-term average.

We don't expect the economy to slow significantly, which should bode well for state tax revenues. However, even if the economy slows and tax revenues dwindle, many states and local governments are still well positioned to weather a slowdown because they used the surge in tax revenues to build up their rainy-day funds. For example, in 2019, the median state rainy-day fund was 14% of a state's total spending. That surged in 2021 and was 28% in fiscal year 2024.

Although we don't have any major concerns about credit quality, we think investors should focus on higher-rated issuers because spreads for lower-rated issuers aren't that attractive. A spread is the additional yield that a lower-rated bond pays compared to a higher-rated issuer. For example, as illustrated below, an index of BBB rated municipal bonds yields 1.92% (192 basis points) more than an index of AAA municipal bonds. That's only four basis points above its average over the past three years. However, spreads for AA rated issuers are 19 basis points more than their three-year averages. Even though we believe that the bulk of a muni bond portfolio should be in higher-rated issuers, a small allocation to some lower-rated investment-grade issuers can be appropriate for some investors because they have higher yields, on average, which can help boost investment income.