The municipal bond market has experienced a surge of new issuance this year. Through the end of September, we’ve seen $424 billion in new municipal bonds come to market, a figure that towers 15% above the same period in 2024 and 29% higher than the five-year average. For context, a typical year sees around $400 billion in new municipal issuance, highlighting that this year is well on pace to surpass that mark.

For investors, this influx of supply has created a technical challenge. With so many new bonds hitting the market, prices have faced downward pressure, causing municipal bonds’ performance to lag their Treasury counterparts for much of the year. However, we believe the fundamental backdrop for municipal bonds remains strong, creating a potential opportunity for patient investors.

Fundamentals for muni bond market remain strong

Although municipal bonds have underperformed so far this year, this is not due to a weakening credit outlook or deteriorating fiscal health. In fact, the fundamentals of the municipal market remain robust.

Across the country, state and local governments are seeing strong tax revenues, resilient consumer activity, and high real estate values that continue to bolster property tax collections. In addition, rainy-day funds—crucial reserves that help governments weather economic storms—remain near record highs.

Overall, state and local governments are well capitalized, with strong balance sheets and dependable revenue streams. Even in the event of an economic slowdown, issuers are well prepared to weather the storm.

Mitigating risk with active management and diversification

In recent months, some areas of the municipal bond market have experienced weakness. Within the high-yield space, several issuers have recently missed interest payments, leading to sharp markdowns in the prices of their bonds. While these events have made headlines, it’s important to recognize that these issues appear to be project-specific rather than indicative of a broader credit deterioration across the municipal landscape.

Still, these events underscore the importance of careful credit selection and diversification. For investors, this is where the value of active management can truly shine. By avoiding concentrated positions in speculative projects and focusing on issuers with solid fundamentals, prudent management teams can help avoid riskier areas of the market while capturing the broader opportunities that are available.

Where do we see opportunity in the municipal bond market?

Despite the technical challenges so far this year, there’s a bright side for investors willing to take a big picture view. Yields in the municipal market are hovering near 3.7%, an attractive level by historical standards. Additionally, relative valuations are compelling when compared to Treasuries and other fixed-income sectors. For those seeking tax-advantaged income, munis continue to present a powerful value proposition.

Looking ahead, the technical pressures that have weighed on the market are beginning to shift, and we expect the pace of new issuance to moderate. With the U.S. Federal Reserve (Fed) beginning to cut rates, we believe this could spark a surge in demand for municipal bonds. This shift could serve as a catalyst to restore balance to the supply/demand dynamics that have been skewed for much of the year.

Should wary investors opt for short duration municipal bonds over cash?

For cautious investors who have been waiting out volatility from the sidelines, the prospect of a new Fed easing cycle presents a timely opportunity to reconsider short duration municipal bonds as an alternative source of yield to money market funds and other cash-like investments.

Historically, money market yields have shown a strong correlation—about 96.0%—to changes in the fed funds rate. While the Fed has signaled a measured approach to future rate cuts, there remains a risk that shifting economic conditions could prompt swifter action, causing money market yields to decline rapidly. Previous easing cycles highlight how quickly this can happen: Yields fell from 4.3% in September 2007 to 0.9% in December 2008, and from 1.8% in July 2019 to 0.7% in March 2020.

Given this dynamic, short duration municipal bonds stand out as a compelling option for investors seeking attractive, tax-advantaged income. As the Fed begins to ease, short duration munis may offer more resilient yields compared to money market assets, providing a valuable alternative for those looking to maintain income in a falling rate environment.

Taking a long-term view

We continue to believe that the municipal bond market offers opportunity for investors as the technical challenges of heavy supply and soft performance are likely temporary. The underlying credit fundamentals remain strong, and the market offers attractive yields for those willing to adopt a long-term perspective.

Looking ahead to the end of the year and the tax-planning season, municipal bonds continue to be a compelling choice for investor portfolios. We believe there is potential for strong municipal bond performance in the last months of the year, with a thoughtful and active approach being key to uncovering any potential opportunities.