Municipal bonds are back

We believe that tax-free municipal bonds continue to be well positioned in the current market environment. Their characteristics warrant a place in most retail investors’ investment portfolios, and not just due to their appeal of relatively high taxable equivalent yields (TEYs). This subsector of fixed income is generally of very high-credit quality with significantly lower default levels relative to other sectors. Historically, it has acted as an important diversifier particularly for equity allocations, and after two straight years of record issuance levels, the technical picture looks solid.

Taxable-equivalent yields (TEYs) remain robust

In most instances, the income from municipal bonds is not subject to federal income tax and can also be exempt from state income tax for investors holding bonds in the state in which they reside. It is essential for comparison purposes to consider this feature when comparing municipal bonds to other subsectors of fixed income which are fully taxable, to get a true apples-to-apples comparison. This can be accomplished through the lens of taxable equivalent yield (TEY), which puts tax-free and taxable securities on an equal playing field.¹ As Exhibit 1 shows, TEYs for the municipal bond sector are attractive across the yield curve relative to both US Treasuries and US investment-grade corporate bonds. As of the end of November 2025, the yield advantage continued to be most pronounced for the intermediate to long end of the curve, as it has steepened.

Credit quality remains high and is improving

The credit profile of the overall municipal bond market is extremely solid, in our view. As of third quarter of 2025, nearly three-quarters of the market was rated AAA or AA, up from less than two-thirds just a decade ago. Most of the remaining credit qualities in the municipal bond space are single A, with less than 10% of the market being BBB rated. Exhibit 2 illustrates this breakdown of credit quality over the last dozen calendar years.

Default level of municipal bonds is very low versus taxable bonds

As you might expect, the high credit quality in the municipal space has led to extremely low default rates for the asset class over the past decade. For every credit tier, from AAA down to CCC, the 10-year cumulative default rate for municipal bonds has been much lower than for corporate bonds of comparable credit quality. Our analysis suggests that in the investment-grade space, defaults have been almost 25 times higher for corporate bonds when compared to their tax-free counterparts over the past decade. Exhibit 3 illustrates the default levels by credit quality rating for tax-free munis versus corporates and splits out investment-grade, non-investment-grade and all ratings.

Municipal bonds can be a powerful diversifier

Over the past couple of decades, municipal bonds have been a very powerful diversifier, particularly to stock market indexes. Tax-free bonds have also had relatively low correlations with their taxable counterparts, especially high-yield bonds and US Treasuries. These important diversifiers can help dampen portfolio volatility in most cases, leading to investors staying invested throughout different market cycles. Exhibit 4 illustrates just how low the correlations have been with both equity and fixed income indexes over the past 20 years.

Technicals appear supportive of munis

Following two consecutive record years of tax-exempt municipal bond supply in 2024 and 2025, the supply/demand dynamics appear poised to return back to more normalized levels. We believe issuance levels will continue to remain high; however, they should be met with strong investor demand. After an incredibly challenging landscape in 2022 led to approximately US$120 billion in net outflows, 2023 was a year of only modest outflows in the municipal market. In 2024 around US$47 billion flowed into the asset class, and 2025 is on track to be another modestly positive year of inflows. Exhibits 5 and 6 illustrate supply and demand in the asset class.