What's Happening in the Muni Bond Market?

LIZ ANN SONDERS: I'm Liz Ann Sonders.

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Every week we analyze what's happening in the markets and discuss how it might affect your investments.

Well, hi, Kathy. Hope all is well with you. So we're in Jackson Hole week as we're recording this. So it's an annual confab with the Fed, and there was a lot of focus on it last year, and maybe this year, not a ton of focus on what the actual topic is, which is thinking about the sort of Fed's process, but lots of focus on Powell himself and what, if anything, he might say about plans for the September meeting. So I'm just wondering … my guess is he's not going to be terribly explicit and will sort of stick to the proverbial script, but do you think this could be a year where his comments are market moving?

KATHY: Well, I would say at least temporarily because, whenever he speaks, we get at least a momentary response. But I would say that I would agree with you. I doubt that he really reveals a specific sort of intention on policy. The Fed's already indicated the median estimate is for rate cuts between now and the end of the year. And the market is betting on September. 

So I don't think that anything he says will kind of deviate from that. I am more interested in a couple of things. The overall topic is about the labor market and how you adjust monetary policy in a world where you have a shrinking supply of labor due to aging populations and various policy moves, deportations, etc.

So how is the Fed thinking about setting monetary policy when half of its mandate is based on employment, and things really are changing in that regard? So I'm sort of interested to see what kind of research they've done on this and what conclusions they might come to. But there's a lot of background noise right now around the Fed. And that may permeate what goes on and what the reaction is.

LIZ ANN: What do you think they'll talk about with regard to their framework, which is part of the topic of the meeting? And do you think they'll announce any adjustments to that framework?

KATHY: Yeah, so part of the Fed … every five years or so they do a review of the framework. And the last time around, the framework was adjusted to have this Flexible Average Inflation Target (FAIT). And that meant that maybe they would allow inflation to float up a little bit above 2% in order to achieve full employment. Because remember, we were coming off of a long, long stretch of very low inflation and a somewhat elevated unemployment rate relative to what it could be.

And so that was the thinking then. Of course, now things have changed, and inflation is up, and the unemployment rate is low. So how do you think about trying to keep inflation low in an environment like this? And that, I think, will be an interesting subject for them to discuss. I think they'll do away with the flexible average inflation target, but I don't …

LIZ ANN: So it'll be a fait accompli?

KATHY: Oh that's bad. That's bad, Liz Ann. 

LIZ ANN: I'll see myself out.

KATHY: But it's good. It's good. It is bad. But yeah, I do think they'll do away with that. I just don't know what they replace it with. Some people speculated that they'll allow the inflation target to move up. I don't think so. I think that would send a very bad signal to markets, and it would cause the U.S. to deviate from most of the rest of the world, which I just don't think they're willing to do. But I don't know what they replace it with. And there's so many variables right now for them to think about: rising debt and deficits and fiscal dominance, meaning efforts to force the Fed to help monetize the debt. There's so many topics that play into this. I'll be very curious to see where they land. What are you thinking?

LIZ ANN: I think the you pointed out, rightly so, I think, that the labor market really holds the key here, you know, barring some shocker of an inflation printout of, say, the Personal Consumption Expenditures index, which is the Fed's preferred measure, and you very rarely get anything that's terribly shocking because you have a lot of the inputs to the PCE that come from Consumer Price Index and Producer Price Index, but I think the labor market holds the key. 

I think another weak report, be it at the headline level, further revisions, I think then you more than pencil in September. I found what was interesting in the aftermath, not so much of the Consumer Price Index, but the release of the Producer Price Index, that saw a little bit of a move down in terms of probabilities that the Fed would cut at the 25-basis-point-level, but you essentially eliminated any chance based on the fed funds future market of the Fed cutting by 50 basis points. We'll have to see what the next labor market report does to those probabilities, but I think the labor market really holds the key. 

The other thing that's been interesting is, first of all, if you dig inside the inflation numbers, you can start to see where there has been some tariff impact. And to me, one of the interesting components that came out of the Producer Price Index was the trade services, which is essentially margins. And that's another indication that there is some pass-through happening. And you're seeing some change in behavior among consumers. And that's been shown by some of the comments that have come out of the retailers. As a reminder, the retailers report a month later than many other companies because their fiscal year tends to end in January, not in December. So I'm paying a lot of attention to what many of these retailers are saying about just business in general, but also some of what we're seeing, which is trading down and being much more cost conscious. So more on that front. 

In terms of the economic data, the housing data is starting to capture more attention, and it's regional in nature, but there's some real, real weak pockets. So we've got more sales and price data coming out in the next week. So certainly keeping an eye on those as well.

KATHY: Yeah, I think the housing market is an interesting topic of discussion. We could probably do a whole podcast, an hour on that. And … affordability is clearly a real problem right now, as it was when I was young, looking to buy a house and mortgage rates were extremely high. Yes, the cost of housing was lower, but it was still …

LIZ ANN: Are you finding you're doing that with young people? "Well, when I was your age …"

KATHY: I try not to. I try not to discuss my floating rate mortgage of 14⅝%, but yes, the cost of the house was much lower, but also the standard of living in the house, so that's much, much lower than, you know, what people expect today. But it's not just the comparison to the past that's important. It's just that affordability is the big problem and I'm not sure if the Fed … you know, the administration would like the Fed to cut rates to make housing more affordable, but I am not sure that that would work. You know, you could just see short-term rates come down and long-term rates stay up or even go higher, and you have high mortgage rates.

LIZ ANN: Mortgage rates went up by almost a full percentage point last fall when the Fed cut by a full percentage point. So absolutely.

KATHY: Yeah. So and we are looking for a steeper yield curve, nonetheless. So I don't think that that's going to be the solution. Other people are talking about getting the Fed to buy more mortgages and stop rolling mortgages off its balance sheet and things like that. So it'll be interesting to see how this evolves. But it's clearly a hot-button issue for lot of voters, particularly younger voters. So I think it's something definitely to keep an eye on.

LIZ ANN: I actually … I had a live client event last night, and you just made me … reminded me of this, had a quick conversation with a very young investor that was in attendance. And it was before we started the formal remarks, and we were talking a little bit about the Fed, and he said, "I kind of get the push for the Fed to lower rates because they're in control of the mortgage rate. Why wouldn't they just lower rates and make it more affordable for us?"

KATHY: If only. If only. Yeah.

LIZ ANN: And if only, it's like, well, that's not the rate that the Fed controls. And he wasn't really embarrassed. He just, he said, "I did not know that. I'm glad you just said that because I wasn't aware. I just assumed that the Fed's lever controlled the interest rates that matter to us like the mortgage rate." So. It was an eye-opening conversation. It's kind of like the tariff conversation when you explain that U.S. companies pay the tariff, not the targeted country, and I still get the, "Oh, I didn't know that."

KATHY: Yeah, speaking of tariffs, one of the things that continues to strike me about this, we have like new tariffs every day, right? Changing levels, new ones rolling out. It looks like now, you know, the reason for tariffs seems to keep changing. But the most recent one, Treasury Secretary Bessent talked about was that bringing in all this revenue, this tax revenue, essentially.

And what a wonderful thing that is for the budget deficit. And I thought, "Well, now we have a reason to keep tariffs or even increase them." And what that does is, instead of this one-time price level shock that everyone kind of expects with tariffs, is a series of price increases over time because it's constantly changing and that there's constantly going up, not down. So you know, it really makes the Fed's framework decisions very difficult because, if this is a new component to the inflation story, and it's so unpredictable, how do you set policy that's forward-looking based on that?

LIZ ANN: And also unpredictable because it's one of those all-purpose tools, apparently, that's not necessarily just about raising revenue but trade deficits and reciprocity and expression of other concerns about countries that are being targeted. So that's another reason why this has just not been and probably won't be a one-time thing. This is a process over time of fits and starts, and I think we're going to see that reflected in the data, too.

All right, so we do have a guest in studio with us today. Works very closely with you, with all of us, but certainly very closely with you, Kathy. So introduce our guest for us.

KATHY: Sure, it's my colleague Cooper Howard. He's a director here at Schwab and a fixed income strategist focusing on the municipal bond market, primarily. Cooper is also a Chartered Financial Analyst. 

Cooper, thanks for being here.

COOPER HOWARD: You know, of course, Kathy, thank you for having me back on.

KATHY: So today I thought we'd focus on one of our favorite topics in the fixed income world, municipal bonds. And this is a big area of the bond market and a very big area for a lot of individual investors. So great to have you here to chat about what's new in the muni bond market. Let's start out kind of high level and basic like, you know, tax rates continue to change all the time. It's funny when people say, "Let's make this tax cut permanent," and there is no permanent tax rate, right? It keeps changing all the time. But with the recent changes, is there … you know, who should consider municipal bonds when investing?

COOPER: Yeah, I think that that's really a great point to start off on. And really where I like to start is kind of defining your goals. Because I think that, not just with municipal bond investing, but kind of all investing, making sense of where you're going, why you're buying this investment, what purpose is it going to serve? That's kind of the bottom line for multiple different things. And when it comes to investing in municipal bonds, but including just bonds in general, there's really three different reasons that we think that they can make sense. One is for income. The second's for capital preservation, and then the third is going to be for diversification. 

But delving into municipal bonds themselves, there are two main benefits to investing in municipal bonds. One is that they have tax advantages, so they generally pay interest income that's going to be exempt from federal income taxes as well as state income taxes. So that's a very important point to determine what account are you buying a municipal bond in, if you are buying one.

So for example, if you're investing in something like an IRA or a tax-advantaged or a tax-sheltered account, usually because municipal bonds have that tax benefit to them, it doesn't make sense to buy them in an IRA. Now, if you're investing in something like a brokerage account that is fully taxable, that's really where it makes a little bit more sense to purchase them. Also, it depends on what is your tax bracket? So for investors who are in higher tax brackets, say the 24% or above bracket, we really think that that's kind of where it makes sense to consider munis. 

The second reason why we do think that munis can make sense is that they're generally very high credit quality. So if we go look at a broad index of municipal bonds, the Bloomberg Municipal Bond Index, which is one of the common indices that we track, about seven out of 10 of those issuers are the top credit rungs. They're either AAA-rated or AA-rated. That tends to be that because they are very high rated, they tend to not miss interest or principal payments that often.

KATHY: Yeah, I mean, that's always one of one of the big appeals is, they … generally the investment-grade part of the muni market has historically a very low default rate. But also nobody really likes to pay taxes, and you know, tax-exempt income is always welcome, particularly if you move into a higher tax bracket. So let's get around to today.

With all those great things for municipal bonds that they have going for them, why have they underperformed other areas of the fixed income market this year?

COOPER: Yeah, so the reason that they've really underperformed is related to a significant amount of issuance this year. So many municipalities have been issuing a substantial amount of debt this year, as well as last year. And if we look at returns, overall year-to-date for that broad index that I mentioned earlier, it's about flat. So it's about zero. Compare that to an indices of, say, the U.S. Aggregate Bond Index, which is just another common proxy that we look at for the total bond market; it's up 4.3%. So they've definitely underperformed quite a bit this year. But again, it's because of that issuance piece. 

So if you look over the past two years compared to two years ago, the amount of bonds that municipalities are issuing is up 70%. And a lot of that is because municipal bonds are issued for different types of purposes. Now I'm in Denver, Colorado, so I'm going to use a little bit of an example here in Denver, Colorado. Just a few years ago, the city authorized the issuance of $975 million of bonds. And the purpose of that was to install air-conditioning units in many of the schools. So in the elementary schools that have been built quite a while ago, they didn't have air conditioning. And so the voters in the city of Denver said that that was an important thing. But the point being is those infrastructure projects are now much more expensive because of the increase in inflation.

So many building costs, many construction costs, are more expensive now than they were, say, a couple years ago. The other reason why there's been a significant amount of issuance this year is that there were concerns that the One Big Beautiful Bill Act, or the tax bill that came to fruition this year, would repeal the municipal bond tax exemption. So a lot of issuers tried to rush to market to get ahead of that to take away that potential risk that might be there.

So those are the two primary reasons why we saw a lot of issuance, and supply and demand tend to have an important part in the muni market. So given that there's been a lot more supply and the same amount of demand, that's caused prices to move a little bit lower and total returns to be roughly flat for the year, so far.

KATHY: So speaking of federal government budget and its influence on the municipal market, are there areas of the muni market that we should be thinking about in terms of the influence of the federal government?

COOPER: Yeah, this is definitely a great question. And I think that one of the important pieces of it is understanding kind of how all the money in the government as a whole, not state government, federal government, local government, because they are three separate things, sloshes around, how they're dependent upon one another. So there is some interdependencies, but there's also some things that are not dependent upon one another. And I'd go back to say, like, the 10th Amendment of the Constitution, for example. So that separates some of the powers that states have versus the federal government has. 

And the other thing that I'd highlight is a major difference between a corporate bond and a municipal bond is that in municipal finance, some of the money that's directly for municipal bonds is earmarked money. So it's something that has to go directly towards that, paying that bond off itself. That's not something like a corporate bond, for example. 

So for long-term listeners of this podcast, one of the things you used to do, Kathy, that I really, really liked, is you would ask some of your listeners, "Well, what books are you reading? Or what are you reading right now that's very interesting?" If you really want to nerd out on municipal finance, I'd suggest "Go read your property tax bill." And you'll see that there are some lines on your property tax bill that say exactly what that levy is going towards. And that's essentially what municipal finance is. So it's that money that you pay in property taxes is going directly towards that municipal bond.

So point being is that there are a lot of issuers that are not directly impacted by the federal government. And if you look in the short term, my view is that many issuers are in a good financial position. So there are a lot of levers that they can ultimately pull if they need to balance their budgets or if they face financial strains. There are a lot of different things that we can look at. In the longer run, there's really four areas that I'm a little bit more cautious on, or I'd suggest watching and seeing how that develops.

The first one's going to be smaller rural hospitals. So going back to the One Big Beautiful Bill Act, it did cut funding for Medicaid, which that can have an impact on smaller rural hospitals that are highly dependent on Medicaid enrollment or individuals who are enrolled in Medicaid. The other piece that we're a little bit more cautious on, or I think that deserves a second look, is looking at some higher-education issuers.

Now, not all higher-education issuers because it is a very diverse market there, and there have been cuts to federal grants. So that could impact colleges with bigger, larger research departments. Again, they do have levers that they can pull and kind of navigate through it, but it does put further strain on their finances. The third area are areas that are more prone to natural disasters. So there has been a shift in disaster funding and moving that shift from the federal government down to states. So that would be a concern for areas that would be more prone to, say, wildfire risk, hurricanes, major natural disasters, for example. 

And then fourth is going to be issuers with more economically sensitive revenue streams. So last quarter, we actually saw the first quarter where the number of downgrades for munis outpaced the number of upgrades. That was the first time going all the way back to the pandemic. A lot of the reason why that was because of the downgrade of the U.S. as a whole, the U.S. sovereign rating. But the other piece about it is that, if you remove that part of it, then you can see that the number of upgrades relative to downgrades has slowed a bit. So point being in that is that it just shows that credit quality in the muni market, although it is very strong, has been historically strong, it probably has peaked.

It is starting to slow. And if we do go through a further economic slowdown, those lower-rated issuers or issuers that are with more economic-sensitive revenue streams, they're likely going to be the ones that are going to face a little bit more of a credit crunch.

KATHY: That brings up a question that we frequently get from investors: what about high-yield or junk municipal bonds? Since munis are generally very high credit quality, why not just go for the highest yield?

COOPER: Yeah, I love how you phrased that question that you called it "junk municipal bonds" because they really only share the name "municipal" with investment-grade municipal bonds. So I think that they are really two different animals, if you will. So yes, high-yield municipal bonds are bonds that are rated below investment grade. They are going to be considered junk municipal bonds or high-yield municipal bonds. They tend to pay interest income like regular municipal bonds that are exempt from federal income taxes and potentially state income taxes. But I do think that they're really a different animal, if you will. 

So I highlighted that some municipal bonds might be backed by property taxes. That's not really true if you look in the high-yield municipal bond space. Those are going to be issuers that don't have very stable revenue streams. They might be used to finance projects that are fairly risky, things that you might not think of as a traditional municipal bond. And there's a reason that they're junk to begin with. 

So about half of the bonds in a commonly quoted high-yield municipal bond index are even not rated. So they're not even junk rated. They have no rating associated with them. But getting back to kind of the here and now of why not consider high-yield municipal bonds? I just don't think that they're paying enough to justify many of the risks for investors. If you look at how much a high-yield bond is paying over and above an investment-grade corporate bond, because they should pay a little bit more because you're taking on more credit risk, that's only about 2.5%. So for an investor in the average high-yield muni index versus an investment-grade muni index, you're only going to get about 2.5% more. 

Compared to the three-year average, that's about 2.75%. So it is below that three-year average. And I think that if you look at the overall kind of health of the economy, yes, things are holding up fairly well, but there are some headwinds on the horizon. So if we do go through an economic slowdown, that's not our call, but if we do go through an economic slowdown, definitely those types of issuers are going to feel the brunt of it much more than the investment-grade portion of the market. And you're just not getting that well compensated for it, in our opinion.

KATHY: Yeah, it's very similar to the situation in the corporate-bond market now where high-yield spreads versus Treasuries are very, very low. And you know, if anything goes wrong, you don't have a lot of cushion there to soften the blow in that market either. So yeah, going back to, you know, just thinking about where to invest in munis, is there any sweet spot on the municipal bond curve or is it every … since it's such a diverse market, is that even a good question?

COOPER: It's a great question, and it really depends on where we are in the market environment. Now today, we do think that an average duration—and duration's just kind of a fancy term to say how far out on the yield curve should you invest—we think about an average duration of about six years can make sense, and that's the same duration of that Bloomberg Municipal Bond Index that I mentioned earlier, but for those investors who have a little bit higher of a risk tolerance or a little bit higher of an interest-rate risk tolerance, longer-term municipal bonds look fairly attractive right now. Now these are going to be bonds that are more sensitive to interest rates. So if interest rates rise, they tend to have greater price fluctuations, can experience greater losses. But overall, if you look at the yields that they offer right now, the average AAA-rated 20-year municipal bond yields about 4.3%. That's before considering the impact of taxes. 

For an investor, Kathy, who's in that highest tax bracket, then that can be over a 7.2% tax-equivalent yield. Given the high credit-quality that they generally offer, we think that that's fairly attractive. Also, that's relatively the highest yield, close to the highest yield, I should say, that they've been paying over the past 10 years. So again, we think that that's where, looking at that, that can be an area of opportunity. The other piece that we like to compare municipal bonds to is one of the metrics that all commonly follow is called the muni-to-Treasury ratio, or some people know it as the MOB spread. And it basically compares what is the yield on that AAA-rated municipal bond to that of a Treasury before adjusting for taxes. 

And right now for 30-year municipal bonds, and I'm not suggesting to invest in 30-year municipal bonds, but I just want to highlight this, to illustrate the attractiveness of them in today's environment, they're paying about 94%, almost near the same exact yield as a Treasury bond before considering taxes. So Treasuries are subject to federal income taxes, munis are generally not. So after you consider that, then that's when we think that the longer portion of the yield curve, especially if you have the higher risk tolerance, can make sense for some investors.

KATHY: So another question we frequently get from investors is, "Do you prefer general obligation bonds or revenue bonds, or are you indifferent?" Does that even matter?

COOPER: Yeah, saying I'm indifferent to the two, it does sound like I'm kind of punting away the question, but that is not a punt away on it. I do think that it really matters to look at what is backing the bond. So I don't think that one is better than the other, but what is the source of revenue that is going to be backing the bond itself? For example, the revenue portion of the market tends to be that there are bonds that are backed by specific revenue sources.

So for example, it might be a healthcare institution, a hospital, a higher-ed institution, or it might be something a little bit more secure like a water utility district. So we all know that no matter what, generally speaking, we're going to pay our water bills. So even if we face an economic downturn, we're going to continue to pay our water bills, and those bonds tend to be fairly secure. Whereas if you look at the general obligation portion of the market, those are bonds that are backed by the taxing authority of that municipality. So they tend to be a little bit higher rated to begin with, but it really depends on the municipality themselves. So I don't think that investors should favor one or the other, but just understand what is backing the bond themselves and then make the appropriate decision from there.

KATHY: And one more question that I often get is, "Is there a benefit to using a mutual fund or an ETF versus buying individual bonds?"

COOPER: I think there are pros and cons to using a mutual fund or an ETF, compared to buying individual bonds. But to me, the main difference is going to be behavioral benefits or behavioral biases. The benefit of using an individual bond is that you know exactly what you're going to get, when you're going to get it, and what type of municipality you're investing in. So what I've found, Kathy, is speaking to many individuals and many investors is they like to know exactly what they're investing in, and they can sometimes look past some of the price fluctuations of that bond because they know, barring default at maturity, they're going to get a certain amount of money back. 

Compare that to a mutual fund. Mutual funds have a price that fluctuates in value. So some investors don't like to see that they consider kind of their safe conservative portion of their investment portfolio fluctuate in value. Now, the upside of a mutual fund or ETF is that for every dollar that you invest, it's spread amongst many different municipal bonds. So you get that diversification benefit. Also, you tend to have some sort of a professional management associated with it. So oftentimes there's some sort of a credit-monitor team watching over those bonds. So for some investors who don't want to do it themselves, they really like that aspect of it. They like that they can buy one specific product. It's spread out among multiple different issuers. 

But in our opinion, it really is just defining who you are as an investor, what's important to you as an investor, and then from there, making the product choice of a mutual fund, an ETF, or individual bonds. I'd also highlight it doesn't have to be one or the other. Sometimes it makes sense to do a combination of both.

KATHY: Yeah, that makes sense. It's the same story with any type of bond or any type of investment. If you do it yourself, just make sure you know what you own and understand how it works and how it fits in the rest of your portfolio. But I personally enjoy trolling through the Schwab website for good municipal bonds. But I understand other people would rather do something else with their free time. So I think mutual funds and ETFs can make a lot of sense for bond investors in general. So Cooper, that's everything that I had reflected from what I hear from clients. Any last words on the muni bond market you'd like to leave us with?

COOPER: Yeah, I think from a high-level perspective, we do think that it is an area of opportunity with where we are right now in terms of yields as well as average credit quality. So the average municipal bond yields about 3.9%. We do think that that's attractive in today's environment, especially after you consider the tax benefits that communities generally offer. Also couple that with credit quality.

Again, we do think that credit quality is probably past its peak, but we don't have any major concerns on the horizon. Yeah, there are some pockets of risk that we discussed a little bit earlier, but overall, there's nothing that's flashing a major warning sign to us. So for those investors who are looking for more conservative, safe investment options that do have some tax benefit to them, we do think that municipal bonds are an area that they should consider.

KATHY: OK, thanks very much Cooper.

COOPER: Thank you, Kathy.

LIZ ANN: That was great. So thanks for that, Kathy. So now is the point in our episodes where we look ahead to the next week or so. What do you think investors should be watching?

KATHY: Well, it's still all about the Fed and the Fed meeting. We don't have the results of that yet. And then we'll look forward to some of the harder economic data that are coming out. But I really do think it's all about the policy formulation and the expectations about Fed policy coming out of the Jackson Hole meeting and then leading into the September 17th Fed meeting. What about you, Liz Ann? Anything else on your radar?

LIZ ANN: Yeah, so I think any labor-market data, of course, we get the weekly claims data, and that has components to it, so initial unemployment claims and then continuing claims. And it's one proxy for this narrative around low-hiring, low-firing kind of backdrop. So not a lot of people getting laid off, but those that have and have filed for unemployment benefits, continuing claims are near a cycle high. So it's just suggestive of folks having a more difficult time finding another job. 

We get the next update to second-quarter GDP, gross domestic product, and of course, we have the Fed's preferred inflation measure, the Personal Consumption Expenditures price index and the components thereof. We'll also get a look at the trade balance as well as imports of goods and exports of goods. So these days, for obvious reasons, some of the trade data can be interesting. So those are the things on my radar.

So that's it for us this week. Thanks for listening. You can always keep up with us in real time on social media. We both post regularly on X and LinkedIn. I'm @LizAnnSonders on X and LinkedIn. Make sure you are following the real me and not one of my many imposters.

KATHY: And I'm @KathyJones—that's Kathy with a K—on X and LinkedIn. And you can always read all of our written reports, including charts and graphs, at schwab.com/learn. If you've enjoyed the show, we'd really be grateful if you'd leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen—or tell a friend about the show. We'll talk to you next week.

LIZ ANN: For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.