Uncertainty is the norm in the capital markets, yet municipal bond investors have recently been forced to grapple with unusually high levels. Record YTD net issuance, rate volatility, monetary policy questions, and Fed leadership speculation have all led to increasingly unsettled markets. But with this uncertainty comes opportunity, and for those seeking tax-advantaged income, high-quality municipal bonds currently offer attractive yields at compelling valuations along with sound credit fundamentals.
Yield Levels Have Increased Considerably
Starting yield has historically proven to be a primary driver of forward bond returns, and today’s levels are noteworthy.
The 10-year AAA yield-to-worst of 3.32% is well above the 5-year and 10-year averages of 2.20% and 2.05%, respectively (as of 7/31/25).1
Furthermore, on a tax-equivalent basis, 10-year AAA bonds are yielding 5.61%, arguably inviting net income given the credit quality of the underlying assets.2
Curve Normalization Offers Substantial Incremental Income
An unprecedented inversion of the municipal curve is now a historical anomaly, and we welcomed further steepening during Q2. As a result, tax-exempt investors can now pick up additional income when extending maturity exposure, as confirmed by the spread between 2 and 10-year AAA maturities increasing from 60 bps on 3/31/25 to 93 bps on 7/31/25.
Incremental curve steepness positions intermediate strategies more favorably relative to shorter maturities, and it offers investors an incentive to move out of cash and equivalent instruments. Furthermore, adding duration in a slowing economy and with Fed Funds rate cuts likely to soon be initiated is worth considering, depending on one’s objectives and risk tolerance.
Relative Valuation Looks Appealing
High-quality municipal bonds are also trading at attractive levels when compared to US Treasuries and equities. Municipal/UST yield ratios, a common valuation metric, have risen substantially from what had been persistently low levels. The bellwether 10-year AAA ratio of 75.97% is up considerably from atypically low sub-60% readings during Q1 2024.
For those seeking alternatives to equities, municipal valuations are by some measures more favorable than has been the case in many years. To this point, tax-equivalent AAA municipal yields are nearly 2% above the S&P 500’s earnings yield.
A Benign Credit Environment
Municipal credit fundamentals also largely remain in a strong position. Acute federal policy pressure on bond issuers has been narrowly focused and primarily confined to Higher Education. Within this headline grabbing sector, as well as elsewhere across the issuer landscape, we favor large, well-run entities with revenue diversity, financial flexibility, experienced management teams, and consistent access to external liquidity.
Many bond issuers have fortified their balance sheets through conservative budgeting and revenue outperformance, and most came out of the Covid era in a better financial position than was initially expected, due in part to federal, state, and local aid.
State reserve fund data offers a compelling indication of fiscal strength as median rainy-day funds relative to expenditures ended FY ’25 modestly below 2024’s peak levels, but far above recent historical averages.
A Technical Tailwind is Anticipated
Supply and demand levels have a great deal of influence on market pricing, and we anticipate a largely favorable technical environment over the next few quarters. The surge in net municipal issuance experienced so far in 2025 is unlikely to be sustained, particularly in sectors such as Higher Education. While we do not expect a sizeable decline in new offerings, even modestly reduced growth in issuance should dampen aggregate net new supply.
As to what may sustain demand, along with the desire of investors to access tax-advantaged income, look no further than the “dry powder” that lies in money market funds. The Investment Company Institute reports that money market fund assets exceed $7 trillion, up almost $1 trillion over the past year.3 Fed watching is currently focused on the timing of rate cuts rather than the direction of policy, and when an easing cycle begins, it may nudge investor assets further out on the curve.
A Favorable Entry Point for Bond Investors?
Absolute and tax-equivalent yields are near multi-year highs, municipal valuations compared to other asset classes are attractive, and credit fundamentals remain sound. While asset allocation and other elements of investment strategy should always be personalized, and what’s seen as optimal for one client may not be for another, we feel financial advisors and tax sensitive investors would benefit from taking a closer look at municipal bonds.
YTW assumes that the investor holds the bond to its call date or maturity. YTW and YTM are two of many factors that determine the rate of return of a bond or portfolio. Other factors include reinvestment rate, whether the bond is held to maturity, and whether the entity makes the coupon payments.
Tax-Equivalent YTW is based on the YTW and an aggregate 40.8% marginal federal income tax rate (37% plus 3.8% tax on net investment income). This calculation is intended for illustrative purposes only to demonstrate the effect of tax-free treatment of municipal bonds on yields.
Investment Company Institute, 7/17/25
This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience.
"After months of negotiations, President Trump signed into law the “One Big Beautiful Bill Act (“OBBBA”)” on July 4th. While there are wide-ranging implications for the economy, individuals, and corporations, it is our opinion that the impact of the OBBBA provisions on the municipal market will be relatively modest..."
"Moody’s Investor Services downgraded the US Government’s credit rating from Aaa/negative to Aa1/stable on May 16th, reflecting accelerating deficit growth and associated borrowing requirements, a fiscal situation exacerbated by recently elevated borrowing costs. Despite considerable attention being paid to federal spending cuts, Moody’s noted a lack of faith in the willingness of Congress to actually reduce the deficit, and US debt levels have now reached thresholds that are materially weaker than other Aaa-rated peers..."
"The high-grade tax-exempt markets are typically characterized by relative price stability, particularly when contrasted with lower grade credits, let alone equities. But it’s been anything but the case so far in April, as extreme volatility has driven up municipal yields at an unusual pace. Advisors and investors are understandably looking for answers, and we aim to provide some below. The primary driver of this turbulence is a liquidity crunch, which has been exacerbated by the factors noted below..."
Economic & Market Commentary
08.04.2025
Don’t Forget About Municipals:
Why Now May Be an Opportune Time to Invest
Uncertainty is the norm in the capital markets, yet municipal bond investors have recently been forced to grapple with unusually high levels. Record YTD net issuance, rate volatility, monetary policy questions, and Fed leadership speculation have all led to increasingly unsettled markets. But with this uncertainty comes opportunity, and for those seeking tax-advantaged income, high-quality municipal bonds currently offer attractive yields at compelling valuations along with sound credit fundamentals.
Yield Levels Have Increased Considerably
Starting yield has historically proven to be a primary driver of forward bond returns, and today’s levels are noteworthy.
The 10-year AAA yield-to-worst of 3.32% is well above the 5-year and 10-year averages of 2.20% and 2.05%, respectively (as of 7/31/25).1
Furthermore, on a tax-equivalent basis, 10-year AAA bonds are yielding 5.61%, arguably inviting net income given the credit quality of the underlying assets.2
Curve Normalization Offers Substantial Incremental Income
An unprecedented inversion of the municipal curve is now a historical anomaly, and we welcomed further steepening during Q2. As a result, tax-exempt investors can now pick up additional income when extending maturity exposure, as confirmed by the spread between 2 and 10-year AAA maturities increasing from 60 bps on 3/31/25 to 93 bps on 7/31/25.
Incremental curve steepness positions intermediate strategies more favorably relative to shorter maturities, and it offers investors an incentive to move out of cash and equivalent instruments. Furthermore, adding duration in a slowing economy and with Fed Funds rate cuts likely to soon be initiated is worth considering, depending on one’s objectives and risk tolerance.
Relative Valuation Looks Appealing
High-quality municipal bonds are also trading at attractive levels when compared to US Treasuries and equities. Municipal/UST yield ratios, a common valuation metric, have risen substantially from what had been persistently low levels. The bellwether 10-year AAA ratio of 75.97% is up considerably from atypically low sub-60% readings during Q1 2024.
For those seeking alternatives to equities, municipal valuations are by some measures more favorable than has been the case in many years. To this point, tax-equivalent AAA municipal yields are nearly 2% above the S&P 500’s earnings yield.
A Benign Credit Environment
Municipal credit fundamentals also largely remain in a strong position. Acute federal policy pressure on bond issuers has been narrowly focused and primarily confined to Higher Education. Within this headline grabbing sector, as well as elsewhere across the issuer landscape, we favor large, well-run entities with revenue diversity, financial flexibility, experienced management teams, and consistent access to external liquidity.
Many bond issuers have fortified their balance sheets through conservative budgeting and revenue outperformance, and most came out of the Covid era in a better financial position than was initially expected, due in part to federal, state, and local aid.
State reserve fund data offers a compelling indication of fiscal strength as median rainy-day funds relative to expenditures ended FY ’25 modestly below 2024’s peak levels, but far above recent historical averages.
A Technical Tailwind is Anticipated
Supply and demand levels have a great deal of influence on market pricing, and we anticipate a largely favorable technical environment over the next few quarters. The surge in net municipal issuance experienced so far in 2025 is unlikely to be sustained, particularly in sectors such as Higher Education. While we do not expect a sizeable decline in new offerings, even modestly reduced growth in issuance should dampen aggregate net new supply.
As to what may sustain demand, along with the desire of investors to access tax-advantaged income, look no further than the “dry powder” that lies in money market funds. The Investment Company Institute reports that money market fund assets exceed $7 trillion, up almost $1 trillion over the past year.3 Fed watching is currently focused on the timing of rate cuts rather than the direction of policy, and when an easing cycle begins, it may nudge investor assets further out on the curve.
A Favorable Entry Point for Bond Investors?
Absolute and tax-equivalent yields are near multi-year highs, municipal valuations compared to other asset classes are attractive, and credit fundamentals remain sound. While asset allocation and other elements of investment strategy should always be personalized, and what’s seen as optimal for one client may not be for another, we feel financial advisors and tax sensitive investors would benefit from taking a closer look at municipal bonds.
This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience.
Municipal Market Implications of the Tax & Budget Bill (“OBBBA”)
Limited Bond Market Impact Expected From US Debt Downgrade
What’s Behind Municipal Market Dislocation?