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Municipal Outlook 2025: Battling Headwinds, Harnessing Tailwinds

Jan 23, 2025
4 min read
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Matthew Norton| Chief Investment Officer—Municipal Bonds
Daryl Clements| Municipal Bond Portfolio Manager—Municipal Fixed Income

Four strategies for navigating crosswinds in the municipal bond market.

The municipal bond market closed 2024 much as it began—highly volatile—providing substantial opportunities for active managers. Broader muni returns disappointed for the year, but bright spots included muni credit, which significantly outperformed higher-rated debt.

Uncertainty around the path forward for interest rates continues to dominate the muni backdrop. While the Fed has signaled it sees some inflation risk, our base case is a short pause followed by more rate cuts.

In this environment, we expect muni returns to be primarily driven by income in 2025. But in our view, the market also faces potential headwinds, including a flood of expected new issuance and renewed scrutiny of muni bonds’ tax-exempt status.

Falling Yields Ahead

As muni investors turn the page from a sluggish 2024, what might they see in 2025? From a technical perspective, we believe issuance will remain relatively heavy—at around $450 billion—which can weigh down the market if demand softens. But demand hasn’t skipped a beat, with some $42 billion flowing into muni funds and ETFs in 2024, according to Lipper.

Income was the dominant driver of returns last year, and we anticipate that trend to continue. With muni yields around 3.7% today, investors’ starting point is especially attractive.

We think the Fed will likely continue to cut rates in 2025, albeit more slowly than originally anticipated, and the muni yield curve should continue to steepen toward a normal slope as short-term yields fall. Moreover, as the Fed eases, bond yields are likely to fall and muni prices to rise.

In fact, yields don’t have to decline by much for munis to see positive returns. If yields do rise, which we think is less likely, they would have to jump 100 basis points (bps) or more to wipe out positive muni returns, thanks to today’s ample yield cushion (Display).

The Range of Potential Outcomes Is Strongly Skewed Today
Expected Returns of Bloomberg Municipal Bond Index Given Change in 10-Year US Treasury Yield from 4.6%
If treasury yields decline, expected muni bond returns are exponentially greater compared to when yields rise by the same amount.

For illustrative purposes only. Current analysis does not guarantee future results.
Simplified illustration based on total return components over 12 months and subject to change
*Implies a 60% beta sensitivity of municipal yields to US Treasury yields
As of December 31, 2024
Source: Bloomberg and AllianceBernstein (AB)

Crosswinds: Strong Fundamentals, but Threats to Tax Exemption

We expect some of the record $7 trillion of cash on the sidelines to begin returning to fixed income—munis included—as cash rates continue to fall. And there are additional reasons for muni investor optimism, starting with solid fundamentals for most bond issuers. Tax revenues are down slightly from record highs, but state balance sheets remain strong. In fact, the median rainy-day cash balance now represents a record 14.4% of states’ general funds.

Take California. The world’s fifth largest economy avoided a record projected deficit in 2024 through effective belt tightening and reserve management. Moreover, Moody’s Investors Service removed the state’s negative rating outlook. Even today’s devasting wildfires, while a major test, have demonstrated California’s strength. Municipalities have historically shown resilience in the face of major natural disasters.

Meanwhile, rekindled talk in Washington over eliminating the tax-exempt status of muni bonds has raised investor concerns. We don’t expect a wholesale removal; lawmakers know that would impede supply and could necessitate raising taxes to fund projects in their jurisdictions.

A more likely relevant outcome of the election is the extension of the Tax Cuts and Jobs Act. The law includes a $10,000 cap on state and local tax deductions, which has been a key driver of muni demand in states with high income taxes. 

Muni Strategies for 2025

From our perspective, this is an opportune time for muni investors to get ahead of rising demand, falling yields and a steepening yield curve.

With that in mind, consider these strategies to get the most out of today’s environment:

Extend your duration target. Lengthening a portfolio’s duration, or sensitivity to interest-rate changes, can help take advantage of falling yields. If yields head lower in 2025 as we expect, longer-duration munis would experience greater price appreciation while also providing steady income for longer. If we’re wrong and yields rise, they’d need to rise significantly to completely erode bonds’ current income cushion. Furthermore, the yield on cash has fallen and the yield on longer-maturity muni bonds has increased, which means investors now receive additional yield for extending duration.

Consider a barbell maturity structure. In 2024, a barbell maturity structure outperformed other maturity structures as the yield curve normalized. It’s still an attractive approach today. A modified barbell structure, which combines short- and long-maturity bonds with select intermediate bonds, could be attractive in 2025, helping investors capture yield and rolldown. Overall, active curve management and opportunistically changing maturity structures will be key.

Look to muni credit. Credit—non-investment grade, BBB- and A-rated bonds—has offered significantly more yield than higher-rated bonds. Credit spreads remain tighter compared to 2024, and while we don’t expect substantial further tightening, current high yields and continued demand for income strongly suggest to us that credit may outperform again in 2025.

Stay flexible. Because relative after-tax yields fluctuate, investors should keep an eye on the relationship between high-grade municipals and US Treasuries. Munis have cheapened recently compared to US Treasuries, so they remain relatively attractive. But investors should be prepared to lean into Treasuries as relative yields change.

In fact, we believe that flexibility in general is key to generating stronger returns. Our research shows that, historically, active municipal bond strategies have outperformed passive approaches 98% of the time over rolling three-year periods and 89% over two-year periods.

Current conditions remain largely favorable for munis, in our view. Municipalities continue to benefit from a relatively strong economic backdrop, and we think that’s unlikely to change. Indeed, we think that today’s high yields, along with expectations of continued rate cuts and a steeper yield curve, make for a timely opportunity for active municipal bond investors who adopt flexible strategies for navigating headwinds and harnessing tailwinds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Matthew Norton is Chief Investment Officer for Municipal Bonds, responsible for overseeing municipal bond investing at AB. He is also a member of the Municipal Impact Investment Policy Group. Previously, Norton was a portfolio manager on the Municipal Bond team. He joined AB in 2005, focusing primarily on research in tax-exempt and taxable fixed-income markets. Prior to joining the firm, Norton worked as a statistical research analyst at St. Lawrence University, evaluating the accuracy of biometric devices. He holds a BS in economics and mathematics from St. Lawrence University and an MBA in economics and quantitative finance from the Leonard N. Stern School of Business at New York University. Location: New York

Daryl Clements is a Senior Vice President and a Municipal Bond Portfolio Manager on AB’s Municipal Fixed Income team, where he is responsible for overseeing the firm’s various separately managed accounts (SMA) and mutual fund assets. He joined AB in 2002 as a municipal credit research analyst, responsible for evaluating municipal issuers nationwide, with a particular focus on the transportation, public power and tobacco-backed bonds sectors. In 2006, Clements was promoted to the portfolio-management team and became a member of the Tax-Exempt Fixed Income Investment Policy Group. Since that time, municipal assets under management have increased from US$22 billion to nearly US$80 billion. Within that growth, Clements spent considerable time expanding and broadening the team’s SMA business. Prior to joining the firm, he was an associate director and municipal credit analyst for Financial Guaranty Insurance Company for six years and a municipal research associate for five years before that with Moody’s Investors Service. Clements holds a BS in business, management and finance from Brooklyn College and an MBA in finance from Pace University. In 2008, he co-authored the “How to Analyze Airport Revenue Bonds” chapter in The Handbook of Municipal Bonds. Location: New York

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