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Written by: JB Golden | Advisor Asset Management
After a rough first half of the year, the prospects for the tax-exempt municipal market seem to be improving heading into the summer months. The 6 bps (basis point) return in May for the Bloomberg Municipal Bond Index was certainly nothing to write home about, but there is a big silver lining that can be taken away from May returns. For the first time this year, investment grade tax-exempt municipals outperformed the U.S. Treasury market on a relative basis. Municipals were ahead of Treasuries by approximately 110 bps in May. The municipal market is also off to a good start relative to Treasuries in June, with municipals up 26 bps on a month-to-date basis, 5 bps better than Treasuries and, while still down year-to-date, seem to have begun the process of clawing back some of the relative underperformance through the first half of the year.
Where Treasury rates were higher across the curve in May, the municipal yield curve steepened with the 5-Year AAA municipal down 18 bps and the 30-Year AAA rate up 10 bps. In fact, the strong steepening on the front end of the municipal yield curve is what drove the relative outperformance versus treasuries for the month of May with returns for municipals positive out to 10 years. The U.S. Treasury curve has already steepened significantly, and municipals seem to be responding in suit. Munis have also lagged the balance of U.S. financial markets in the post-liberation day recovery. Equity markets, U.S. Treasury markets and both Investment Grade and High Yield corporate markets have all rebounded since the April 2 tariff announcement with both positive returns in the aftermath of the tariff announcements and on a year-to-date basis. Municipals, on the other hand, have faced a host of headwinds, have struggled to keep pace with other asset classes and have posted negative returns both post liberation day and year-to-date. The recent outperformance relative to treasuries as well as the steepening of the municipal yield curve could be indications that the municipal market is in the early stages of playing catch-up.
Broad interest rate volatility has certainly had an impact on the municipal markets year-to-date, with the volatility especially sharp on the longer end of the yield curve. That said, municipals, even after a strong June, lag Treasuries by over 340 bps and investment grade corporates by almost 360 bps on a year-to-date basis. This speaks to the notion that there has been a lot more going on in the municipal market than interest rate volatility through the first half of 2025. Interest rates likely provide some insight into the volatility on the long end of the municipal curve but there have been unique headwinds that have challenged the municipal market this year. Namely heightened political/legislative risk and heighted new issuance. In the last month the market has gotten a bit more clarity on the political front and the market has done an admirable job digesting record setting supply. It seems likely that these factors could also be part of the catalyst behind the recent outperformance relative to Treasuries.
State and local government debt has been in the crosshairs from a political standpoint for the balance of this year. From reductions in the levels of federal funding, to legislation that could potentially lead to cuts in programs like Medicaid, to threats to the tax-exempt status of private universities, the market has even dealt with chatter that the tax-exempt status of municipal debt could be removed as an avenue to pay for tax legislation. In the last month, markets have gotten the first view of both the House GOP and the Senate GOP’s version of the “One Big, Beautiful Bill Act” and municipal markets should be unfazed by any of the potential proposals. The House and the Senate remain far apart on many issues, so it remains to be seen what the final product will look like but regarding municipals, any headwinds related to the tax legislation should be in the rearview mirror.
Both versions of the bill would maintain the tax-exempt status of the market including all current issuers and the tax regime should be little more than maintaining the status quo as it keeps the current income tax brackets and rates in place. The biggest impact is likely changes to the SALT (State and Local Tax) deduction, potential reductions in funding to programs such as Medicaid and a proposed increase in the endowment tax for private universities and colleges. If residents of high tax states such as New York and California can deduct more in state and local taxes it reduces the value of any municipal exemption. The House version of the bill proposed increasing the SALT deduction from the current level of $10,000 to $40,000. The Senate version of the bill did not address the deduction and left it at the current level of $10,000. It seems likely that the two sides could meet in the middle, but both ends of the spectrum seem like something that the market can easily digest.
Increases in endowment taxes could have some sector-specific impacts, but the proposal is aimed at institutions that have at least 500 students and endowments worth more than $2 million per student — which would only impact Harvard, Yale, MIT and Stanford. In the same vein, if the states are required to shoulder a larger burden of Medicaid, it could have some credit-specific implications, but reliance on Medicaid at the state and local level as well as reliance on Medicaid for many healthcare institutions is publicly available information that the market can digest and price in via wider credit spreads.
Continued reductions in the level of federal funding to state and local governments do seem likely whether via the tax legislation or some other manner. In fact, many would argue that this is a catalyst spurring the increase in the issuance of new debt. The municipal market has been awash in new issue debt through the first half of the year, and it seems likely that it is one of — if not the main reason — municipals have lagged Treasuries and corporates year-to-date. Roughly six months into the year, issuance is up 15% on a year-over-year basis. Issuance year-to-date through the first quarter of the year totaled $111.4 billion, the second highest quarterly supply total on record, trailing only the $115 billion issued in the first quarter of 2007. More recently, however, the increase in new issue debt has been less of a headwind as reinvestment demand has increased. The market digested $50 billion in new issue supply in May while still outperforming Treasuries by over 100 bps, then digested $20 billion in the first week of June, the second highest weekly supply total this year, then followed that up by putting $17 billion away the second week of June. The market is hurtling toward the heaviest reinvestment period of the year with the balance of June, July and August ahead. The municipal market’s ability to digest record-setting supply is not likely to be tested again until the back half of the year. With valuations, as measured by yields, hitting historically attractive levels, for the first time this year valuations and demand seem to be aligned and a headwind to tailwind theme seems to be in play for municipals heading into the summer.
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