Five reasons why municipal bonds are compelling post-election

With the presidential and congressional elections in the rearview mirror, we’re now focused on the road ahead. Here are five key reasons to consider an allocation to tax-exempt munis now.

1. Unified government has mostly been good for munis

Many financial pundits have said a divided government is good for the markets, but unity has also been good for municipals. Four of the last five periods of unified government have created positive returns in the municipal market, with lower credit quality usually outperforming. (See chart below.) Remove the period with the end of a global pandemic and aggressive rate increases, and the remaining four united periods have averaged 8.70% for the investment grade index and 21.67% for the high yield index. Of course, past performance is not a guarantee of future results.

2. Yields are attractive

Bonds are back to acting like bonds, and this includes munis. Today's yields are attractive, providing higher income levels and lowering the correlation between bonds and equities. Muni bond yields are higher than they’ve been in the past several years following two years of unprecedented interest rate hikes by the Fed. The good news is that the Fed has finally begun to cut interest rates. The great news is we’re only in the early innings of the easing cycle. The muni market has experienced 23 consecutive weeks of net inflows, into municipal mutual funds, resulting in more than $42 billion of positive flows year-to-date as of December 4, 2024.¹ Yet, there remains more than $7 trillion on the sidelines in money market funds.² When these dollars truly start to go to longer duration options, the muni market should benefit, resulting in lower yields and higher prices. 

3. Tax exemption is key 

As always, taxes are what matter the most for munis. Trump’s victory and red sweep will likely result in an extension of the Tax Cuts and Jobs Act of 2017. This act capped itemized deductions of state and local property taxes (SALT) at $10,000, which effectively increased individuals’ state tax rates. This, in turn, was viewed as a driver of demand for tax-free municipals, particularly in high tax states like California, New York, and New Jersey. An additional 3.8% tax on wealth — levied by the Affordable Care Act and exempt from muni income — drives the total tax rate up to 40.8%, which is higher than the George W. Bush years of 37% and only 2% lower than the Obama years. We believe there will likely be no change in top individual tax rates, and the SALT cap will remain in place, possibly with an increase in the deduction cap, which should keep munis in high demand. If an investor in the highest federal tax bracket earns 4% in a tax-exempt municipal bond fund, they would need to earn 6.75% in a taxable fixed income investment to take home the same amount of money after taxes. If they earned 5% in a municipal fund, they need almost an 8.5% tax-equivalent yield, and that doesn’t account for potential state taxes.³

Additionally, there have been some reports that the municipal tax exemption could come under increased scrutiny. While this makes for a snappy headline, we believe the muni tax exemption, which was established over 100 years ago, is safe. If something were to happen to the exemption, we strongly believe existing muni bonds would be exempt from any tax law changes, which would make the existing exemption more valuable.

4. Steeper yield curve indicates value 

Municipal investors should benefit from higher yields on the long end compared to the relatively flat US Treasury curve, as the chart below shows.

5. Credit fundamentals remain robust

Municipal bonds have a long history of low defaults compared to corporate bonds, because they fund essential US services. Credits are currently very strong, and in 2024, we’re seeing two credit rating upgrades for each credit rating downgrade.⁴ This is on the heels of a nearly 4-1 upgrade to downgrade ratio in 2023. Additionally, all states are investment grade, with 48 of the 50 having credit ratings of AA and higher.⁵ This is due to strong balance sheets, robust rainy day fund balances expected to end higher than the previous fiscal year, and, state and local taxing bodies collecting higher revenues than in pre-COVID-19 years.

What’s notable is that the state and local authorities have been fiscally responsible with the influx of cash, beefing up reserve funds instead of spending the money frivolously or on new programs that would be difficult to maintain without a continuous flow of federal dollars. This means that the vast majority of municipal bonds have the ability to continue paying principal and interest to bondholders.

Potential bonus reason 

Many municipal market participants, our team included, view the nomination of Scott Bessent as Treasury secretary in a positive light. Bessent understands fixed income markets and is likely to be a strong supporter of the municipal tax exemption.

Quick sector views

Charter schools

The Republican-led House Appropriations Committee supported increasing charter school funding. The potential for increased federal funding would be a credit positive for the sector.

Tobacco: Master Settlement Agreement (MSA) 

This sector lagged in 2024 and is among the least expensive parts of the high yield municipal market. Several things may benefit MSA tobacco bonds: The next chief of staff, Susie Wiles, is a former tobacco lobbyist; regulators might begin to snuff out illegal cigarettes, which decreases MSA participant's market share, and a proposed ban on menthol cigarettes could be paused or abandoned. 

Transportation

Increased tariffs could have a negative impact on certain subsectors within transportation. A reduction in imports and cargo shipments could decrease margins at ports, and, to a lesser degree, some airports.

Conclusion

Muni bonds are compelling in the current environment, especially when investors begin to seek duration as the Fed continues its monetary easing cycle. We believe a favorable macroeconomic environment — attractive yields, positive market technicals and credit fundamentals, election results, and an eventual return to longer-term investments as investors move out of cash ­— suggest potential positive muni performance ahead.