The municipal bond market outlook: Continued stability—a good sign for investors

2025 recap:

• Political and policy uncertainty dominated the headlines for much of the year, and the Federal Reserve’s interest-rate policy drew heightened attention as it delivered three consecutive cuts of 25 basis points each.
• The municipal yield curve steepened during the year, due to persistent insatiable demand for short-term, high-quality municipal bonds and modest flows into longer maturities.
• Although supply remained robust, substantial demand served to balance the market and was a stabilizing factor in the second half of the year. 
   

2026 outlook:

• Technical factors strengthened in the second half of 2025, and moving forward, we believe investor interest in appealing yields will be an important trend to monitor.
• Fundamentals remain stable as state and local governments continue to have ample rainy-day funds and the health of the US economy remains intact to support continued revenue for municipal projects.
• In our analysis, municipal bond valuations remain attractive, offering absolute yields that are likely to appeal to investors, especially in the 20-year and 30-year segments of the municipal yield curve.
   

Looking ahead to 2026, we believe there are a few key factors that will likely shape the municipal bond market, which remains what we consider an attractive option for long-term investors interested in income generation and potentially stable returns. In 2025, while municipal bonds underperformed relative to other fixed income segments, they delivered positive returns and remain appealing to us due to their stability and favorable valuations. In our analysis, current absolute and relative yields may provide compelling opportunities, with valuations that cannot be found in other fixed income sectors.

Technical factors had a significant influence on the municipal bond market throughout 2025. These factors, encompassing supply and demand imbalances as well as investor sentiment, played a crucial role in influencing overall performance and valuation trends. The impact of these technical elements highlighted the importance of monitoring market structure and investor behavior when evaluating investment opportunities in municipal bonds. We are intently focused on how investors’ preferred investment vehicles are evolving and how they access our municipal bond capabilities.

Looking ahead to 2026, demand is expected to play an even more crucial role in driving market developments. With 2025 setting new records for supply levels, projections suggest that 2026 should also reach exceptional highs. This projection is primarily attributed to capital requirements for infrastructure, which can no longer depend on previous government stimulus programs. As investor interest remains strong, and supply dynamics persist, the balance between these forces will likely determine yield movements, pricing and overall returns within the sector. The anticipated heightened investor's interest in securing higher yields underscores the need for ongoing attention to investor sentiment and participation, which will be key in navigating the evolving municipal bond landscape.

In our opinion, fundamentals remain stable; however, slower economic growth will likely limit growth in revenues across many sectors, in particular tax revenues. Rainy day funds remain healthy at the state and local government levels, which should help manage continued growth in expenses. The disparity between upgrades and downgrades in the municipal bond market continues to diminish, but there is no deterioration in fundamentals across the municipal market.

Some sectors have been experiencing more downgrades than upgrades, a trend that will likely continue. Idiosyncratic credit events, such as the Brightline Railway project, often attract public attention. However, it is important to evaluate the potential repercussions for the wider municipal market. In this instance, we believe the scope of the project does not have a significant effect on the municipal sector as a whole. Rigorous credit research remains crucial, and our research team has successfully navigated numerous economic cycles. Their expertise informs each stage of the municipal bond investment process, including issuer selection and risk management.

In our analysis, valuations are less compelling across most other asset classes and fixed income sectors, but the underperformance in 2025 provides the municipal bond market with what we consider a more attractive entry point to start 2026. While most taxable sectors now have spreads that are near or at recent lows, the municipal market has valuations that are above or at three-year averages and well above three-year lows.