Municipal bond market opportunity: Now is the time to act
Examining why a market sell-off driven by misplaced fears could create an investment opportunity.
The long end of the municipal bond market has experienced a rare and sharp dislocation. Despite possessing strong credit fundamentals, the higher-quality, longer-duration municipal bonds—especially the AAA-rated tranche—have suffered a significant selloff in the first quarter of 2025. This decline wasn’t driven by deteriorating credit conditions, but rather by technical pressures and by fears about changes in tax policy that, in our view, were misplaced. Unlike taxable bonds that must contend with losing sponsorship from foreign investors, tax-exempt bonds are purely domestically geared vehicles that are not susceptible to the whims of global investor sentiment.
A speculative article from the American Enterprise Institute ("Making-the-Tax-Cuts-and-Jobs-Act-Permanent") suggesting that the interest earned from municipal bonds might lose its tax-exempt status sparked widespread concern. This triggered a wave of retail-driven outflows ($1.2 billion in the final three weeks of March alone), causing forced sales in a market already adjusting to new issuance and tariff-related economic uncertainty. We feel the speculation that municipal bonds might lose their tax-exempt status is overblown.
In the remote event that the tax-exempt benefit is revoked, existing tax-exempt bonds would be grandfathered in to the current rules and that would make them substantially more valuable. The Tax Policy Center estimates that taxing the interest on municipal bonds would generate only about $20 billion in additional yearly revenue for the federal government. The members of Congress appear to be moving in another direction. They are considering increasing the marginal federal tax rate by 3% for those with incomes above $1 million. It is estimated that the higher marginal tax rate would generate an additional $40 billion annually in federal revenues. Increasing the tax rate on millionaires is a bit more palatable to all taxpayers and more accretive to federal coffers. The latter route would also make owning tax-exempt bonds even more attractive for those in higher tax brackets.
As a result of this perceived uncertainty, the municipal bond yield curve steepened dramatically, and the relative value of munis versus taxable bonds has become extraordinarily attractive. Our proprietary Net Implied Tax (NIT) metric reached 19%—a level historically associated with strong forward returns. The Net Implied Tax is our proprietary measure that suggests the break-even federal income tax rate required for investors to consider municipal over taxable bonds. The 30-year AAA muni/Treasury ratio cheapened by 15 percentage points. That constituted one of the widest dislocations in recent memory.
Taxable-equivalent yields are extraordinary considering the high-quality nature of the municipal bond market.
Figure 1: Attractive taxable-equivalent yields for high-quality municipals
Long-duration security | Taxable-equivalent yield, using a 40.8% federal tax rate | Rating |
Tax-exempt munis | 7.53% | AAA |
US Treasury | 4.72% | AAA |
Investment-grade credit | 5.94% | A |
High yield credit | 8.1% | B |
Source: Bloomberg, Schroders
For investors, this environment is reminiscent of past mispriced panic events, such as the 2010 Meredith Whitney municipal default call and the 2013 Taper Tantrum. Both episodes ultimately presented excellent buying opportunities for patient investors.
The histogram below provides a helpful picture of when it is potentially an attractive time to invest in tax-exempt municipals. We believe now is such a moment.
Figure 2: Municipal valuations: Net implied tax rate
Frequency of observations
Source: Thomson Reuters and Bloomberg, through March 31, 2025. For illustration only, based on the views of the Schroders US Multi-Sector Fixed Income team. These views do not constitute a recommendation to buy or sell any security.
What looks attractive to us:
• High-quality, long-duration municipals: Investors are being compensated to stick with quality. Yields among the higher-rated bonds rival those of riskier credits.
• Property tax-backed general obligation bonds: Stable revenue sources make these bonds particularly attractive.
• 100% agency-enhanced housing bonds (single & multi-family): These municipal mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS) instruments are robust and well-rated, while also offering compelling spreads.
Municipals have long been a cornerstone for tax-sensitive investors. With economic slowing, potential increases in top marginal tax rates, and a likely end to tariff-driven volatility, our view is that the current climate presents a textbook opportunity to enter or increase positions in long-dated tax-exempt bonds.
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