Three Key Questions Facing the Muni Bond Market
We're only six weeks into the new year but it already has felt like a lifetime for investors. Geopolitical risks, concerns over the path forward for the Federal Reserve, and artificial intelligence being either the savior or the downfall of the economy have rattled the riskier segments of the markets. That has created many questions for investors. Here we're going to tackle three big questions facing the muni market right now.
Can the strong performance continue?
We expect munis to post positive total returns this year but we would not be surprised if the pace of returns slows. The Bloomberg Municipal Bond Index is up 1.5% year-to-date as of February 12th, 2026, which is among the best starts to a year since 2020. The muni market has historically performed well at the start of the year due to a mismatch between supply and demand. Many municipal bonds pay interest and principal that comes due in December and that money is often reinvested in January. The strong demand pushes prices higher and is supportive of total returns. Total returns are a combination of changes in prices plus coupon income.
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Munis are among the best-performing fixed income asset classes so far this year
Source: Bloomberg. Total returns from 12/31/2025 through 2/12/2026.
Bloomberg Municipal Index Taxable Bonds (Taxable Munis), Bloomberg U.S. Corporate Bond Index (IG Corporates), Bloomberg US High Yield Very Liquid (VLI) Index (HY Corporates), Bloomberg U.S. Aggregate Index (US Aggregate), Bloomberg U.S. Treasury Index (Treasuries), Bloomberg Municipal Bond Index (IG Munis), Bloomberg Muni High Yield Index (HY Munis). Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Due to the strong start to the year, municipal bond yields are low relative to Treasuries of similar maturities. A metric that we commonly follow to gauge the relative attractiveness of highly rated munis is the municipals-over-bonds (MOB) spread, or muni-to-Treasury ratio. It's a ratio of the yield on a generic AAA rated muni compared to a Treasury of equal maturity before adjusting for taxes.1 As illustrated in the chart below, muni-to-Treasury ratios of all but the 30-year tenor have declined over the past month and are near the lowest level over the past year. For example, the yield ratio for a 10-year AAA muni compared to a 10-year Treasury is about 62%, which is down from a month ago and at the lowest level over the past year.
Muni-to-Treasury ratios have generally declined over the past month
Source: Bloomberg.
BVAL AAA Munis as a % of Treasury. As of 2/12/2026 and 1/12/2026. 1-year range begins on 2/12/2025. For illustrative purposes only. Past performance is no guarantee of future results.
Low relative yield ratios don't bode well for returns relative to other fixed income investments in the near term. Historically, when the 10-year muni-to-Treasury ratio is below 70%, as it is now, munis tend to underperform Treasuries over the subsequent 12 weeks. Part of the reason why is because when yield ratios are very low, by definition muni yields are low relative to Treasuries and investors tend to gravitate toward the higher yielding investments. This results in less demand for munis and causes yields to rise relative to Treasuries resulting in underperformance. It's important to note that these are averages and there have been many instances where munis outperformed Treasuries even though yields relative to Treasuries are low.
Munis have historically underperformed Treasuries when MOB spreads are low
Source: Bloomberg. Weekly data from 12/30/2005 to 2/6/2026.
BVAL AAA Muni Yield % of 10 Year Treasury Index (MUNSMT10 Index). Munis represented by the Bloomberg Municipal Bond Index (LMBITR Index), Treasuries represented by the Bloomberg US Treasury Bond Index(LUATTRUU Index). Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results. For illustrative purposes only.
Another potential headwind for near-term performance involves seasonal factors. Since 1980, the worst month, on average, for the muni market has been March. That's largely because some investors liquidate all or a portion of their muni holdings to help pay for their tax bill that's due in April. This pushes prices lower, resulting in weak total returns (remember, however, that past performance is no guarantee of future results). We don't believe that the potential near-term headwinds should cause investors to wait to invest. A benefit of owning fixed income, which includes munis, is that every day that an investor is invested, they're earning income which can build up over time.
March has historically been the worst month for muni total returns
Source: Bloomberg.
Bloomberg Municipal Bond Index (LMBITR Index). Monthly data from 1/31/1980 to 1/31/2026. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
How could federal withholding of funds impact munis?
The relationship between the federal government and state and local governments is complex and governed by legal precedent and laws so the impact to the muni market is very nuanced. Recently, the current administration has threatened to withhold federal funds from Democratic-led states and local governments that limit cooperation with federal authorities. According to the Urban Institute, the withholding of funds could impact up to 500 counties, 40 cities and seven states. This is not the first attempt to limit or restrict federal funds that flow to states. There have been previous attempts to cut these funds but they've faced many legal challenges, with courts ruling such actions are uncon-
stitutional.
Looking at the issue through the eyes of the muni market, we don't believe that it is a major risk to the broader market but do believe that it poses a risk to some issuers. Generally speaking, the money that is used to pay debt service comes from the general fund, a specific tax source, or usage fees. For example, most states derive the majority of their revenues to pay for debt service from income and sales taxes and not federal funds. Local government bonds are often backed by a specific property tax and are not directly impacted by the federal government. Additionally, some municipal bonds, known as revenue bonds, are backed by usage fees such as water and sewer utility districts which often derive the majority of their revenues from water and sewer bills.
The risk to revenue bonds varies more than general obligation bonds in our view because federal funding has little to no impact on some issuers but a greater impact on others. Broadly speaking, we are less concerned with issuers that have higher credit ratings because they generally have more stable revenue sources, greater financial flexibility, and more liquidity, and can better manage the potential changes.
In our view, the risks of changes to federal policy will continue to linger over the muni market but are more of a headline risk to the whole market than they are a credit risk to the whole market. Headline risk refers to the idea that some muni holders liquidate their positions due to a news headline which pushes prices lower.
Where are the potential opportunities in the muni market today?
Overall, we think the muni market is an area of opportunity because it can offer attractive tax-adjusted yields and credit quality is currently stable, in our view. For most investors, we suggest a benchmark duration of about six years for the average muni investor. Although yields have moved lower recently, they are still well above their lows of 2020 and 2021 and are attractive after considering tax benefits relative to comparable alternatives.
Munis may yield more than alternatives for investors in higher tax brackets
Source: Bloomberg as of 2/12/2026.
Bloomberg US Corporate High Yield Bond Index (LF98STAT Index), Bloomberg EM USD Bond Index (EMUSSTAT Index), Bloomberg US Corporate Bond Index (LUACSTAT Index), Bloomberg US Aggregate Bond Index (LBUSSTAT Index), Bloomberg US Treasury Bond Index (LUATSTAT Index), Bloomberg Municipal Bond Index (LMBISTAT Index), Bloomberg Global Aggregate ex-USD Bond Index (LG38STAT Index). The 40.8% tax rate assumes a 37% federal income tax rate and a 3.8% Net Investment Income Tax (NIIT); calculation does not include a state income tax. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
For investors who are comfortable taking on additional interest rate risk, we believe longer-term munis are worth consideration. Duration risk is the risk that the price of an existing bond will decline if interest rates rise. Prices for longer-term bonds are more sensitive to changes in interest rates than shorter-term bonds.
Although relative yields for highly rated munis inside of 10-years are rich, the same can't be said about longer-term munis. The 30-year muni-to-Treasury ratio is roughly 87%, which is much higher than munis with shorter maturities. As illustrated in the chart below, yields for AAA rated munis and Treasuries after taxes are nearly the same for maturities inside of 10 years. However, further out the yield curve, munis offer a yield advantage of over 100 basis points, which is the equivalent of 1.0%.
Longer-term munis may make sense for some investors
Source: Bloomberg, as of 2/12/2026.
Municipal bonds are represented by the Bloomberg BVAL Muni AAA Yield Curve. Treasuries assume a 37% tax rate and 3.8% NIIT. For illustrative purposes only. Past performance is no guarantee of future results. The BVAL Muni AAA Yield Curve is the baseline curve for BVAL tax-exempt munis. It is populated with high quality U.S. municipal bonds with an average rating of AAA from Moody's and S&P. The yield curve is built using non-parametric fit of market data obtained from the Municipal Securities Rulemaking Board, new issues calendars, and other proprietary contributed prices. Represents 5% couponing.
For investors interested in longer-term munis, we generally don't suggest going out too far because there are still compelling opportunities with short- or intermediate-term maturities. A barbell strategy could make sense for investors wanting to add longer-term munis because it combines some short-term bonds, which offer potential stability and liquidity, and some longer-term bonds, which are more attractively valued in our view. However, longer-term bonds are more sensitive to interest rates than short-term bonds. If rates rise, prices for longer-term bonds will likely decline more than short-term bonds which could result in underperformance or even negative total returns.
What to consider now
The road ahead for the muni market could be choppy but there are likely sunny skies on the horizon. We think investors who are looking for relatively conservative tax-advantaged income should consider munis. However, currently low valuations, issuers' financial relationship with the federal government, and other risks could make for a bumpy road in the near-term. That's not to say that investors should wait or avoid investing, but they should be prepared for some potential volatility.
1 The Moody's investment-grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment-grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.
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