Outlook on Municipal Bonds: Seeking Opportunity Amid Volatility

Managing volatility and seeking compelling opportunities

As early April’s global market volatility spilled over into the tax-exempt asset class, benchmark municipal yields rated AAA jumped 85–100 basis points (bps) over a three-day period – one of the largest moves in municipal market history.^Footnote1 Longer-dated municipals sold off to levels that indicate value, with 30-year municipals rated AA trading in line with 30-year Treasuries.^Footnote1

This was driven by a perfect storm as reinvestment capital dipped, creating a weak technical environment, and the market experienced the worst week of outflows since 2022.^Footnote2 Excess selling from the retail buyer base, likely driven by heightened volatility and efforts to raise liquidity for tax payments, exacerbated muni market liquidity to levels not seen since 2020. These episodes, when technicals temporarily dominate fundamentals, have become more frequent and are expected to persist, creating opportunities for managers who construct portfolios with this dynamic in mind.

Since the sell-off, absolute valuations have become exceptionally attractive for tax-aware investors. The Bloomberg Municipal Bond Index yield to worst reached 4.29% (7.24% on a taxable-equivalent basis^Footnote3) on 11 April, a level exceeded on only 24 trading days over the past 15 years; it offered 238–296 bps in excess yield over other high-quality taxable fixed income indices on a tax-equivalent basis.^Footnote4

Relative valuations make a case for a measured approach to lower-quality credit, where price discovery has been limited despite recent volatility and increased probabilities of recession, keeping spreads at compressed levels. As of 11 April, the spread between the Bloomberg High Yield Municipal Bond Index and the Bloomberg Municipal Bond Index is 170 bps, which is 54 bps below its five-year average and near multi-year tights.^Footnote4 Although select opportunities offer compelling value, we are focused on building resilience within municipal portfolios.

We see ample opportunities, particularly at the long end and in housing:

Thirty-year munis rated AA yielded 4.86% (8.21% on a taxable-equivalent basis^Footnote3) as of 11 April, offering a 334-bps taxable-equivalent spread over 30-year Treasuries.^Footnote1 The tax-exempt municipal curve remains upward sloping, with yields on 30-year munis rated AAA 98 bps above 10-year yields – compared to 38 bps on the U.S. Treasury yield curve.^Footnote1 With institutions having stepped away from the long end of the curve due to lower corporate tax rates and fund flows remaining under pressure, this dynamic will likely persist. PIMCO aims to capitalize on this through active yield curve management, enhancing carry and roll-down.

Tax-exempt mortgage pass-throughs (MPTs), composed of housing loans from state and local housing agencies, are among our highest-conviction ideas. Purchases by banks – traditionally, the largest buyers – have declined due to lower tax rates diminishing their appeal as well as reduced appetite for longer-duration securities. Another advantage: MPTs are excluded from most municipal benchmarks, and their complexity reduces demand from traditional muni managers. Rated AAA, they have an effectively explicit government guarantee given Fannie Mae and Freddie Mac’s entry into conservatorship in 2008. With recent yields of 4.5%–5.0%, they rival credits rated BBB.^Footnote4

Tax-exempt multifamily housing loans are attractive, especially those on properties offering below-market rents that are senior in the capital structure and have low loan-to-value ratios. Many properties enjoy strong demand and high occupancy, even in challenging economic conditions. These housing-related loans offer a significant yield advantage over broader investment grade and high yield indices.

Policy implications

While debate continues over the tax exemption of municipal bonds, and over Medicaid cuts, we believe the outcomes will be less severe than current proposals. Ultimately, we expect most sectors of the municipal bond market to demonstrate resilience, supported by strong fundamentals and flexible budgets.

Will muni bonds lose their tax-exempt status?

We believe it’s highly unlikely. Though repeal could save the federal government $250 billion over 10 years,^Footnote5 it would cost municipalities nearly $1 trillion.^Footnote6 For over a century, municipal bonds have retained their tax-exempt status, enabling lower-cost funding for capital projects and garnering bipartisan support. While private activity bonds and debt for higher education and healthcare are frequent targets, we expect these securities to stay tax-exempt. If future issuance becomes taxable, existing debt will likely be grandfathered in, boosting valuations for outstanding debt as the market shrinks.

Will cuts to Medicaid damage municipal budgets?

Federal transfers account for over a third of state revenues,^Footnote7 with Medicaid as the largest component.^Footnote8 We believe states, which share the costs of Medicaid with the federal government, will remain resilient. Although the House Republicans’ proposal to slash $880 billion over 10 years would represent significant savings for the federal government, we believe that enacting cuts of this magnitude would be challenging. If cuts are made, states will have discretion to modify their programs, making even severe reductions manageable.

What about healthcare systems?

Cuts could hurt margins for not-for-profit healthcare providers. Major systems with structural advantages to address margin challenges will likely be able to manage lower reimbursements without significant stress. However, financially weaker systems may struggle.

Will funding cuts lead to severe local government credit stress?

Local funding, primarily targeted to K-12 education, is expected to persist despite efforts by the administration to dismantle the U.S. Department of Education. However, uncertainty looms: Certain cities may face targeted reductions, and proposed cuts could give rise to significant legal challenges. We believe that local governments are well-equipped to effectively manage these pressures, while localities will continue to benefit from a large dispersion between assessed property valuations and current market values. House price appreciation has been significant, and with roughly 73% of local tax revenues coming from property taxes, this should drive positive momentum for property tax collections as assessed values catch up.

Will funding cuts for education and research harm schools?

Federal education policy, potential cuts to research funding, and the possibility of additional endowment taxation will present headwinds for the sector. Although major institutions with strong brands, stable or rising enrollment, and robust public and private support are well-positioned, weaker segments, especially smaller private universities, will remain severely pressured.

Strong fundamentals: reserves, revenues, and leverage

Credit fundamentals for state and local municipalities remain robust, supported by substantial reserves, stable revenue streams, and declining leverage. Over the past year, tax collections have surpassed pre-pandemic levels, with 2024 collections rising 32.3% versus 2019.^Footnote9 Total state balances, including rainy-day funds, are nearing record highs, accounting for 24% of expenditures in fiscal year 2024 – well above the 10-year pre-pandemic average of 8.9% and the 20-year low of 4.6% during the financial crisis (see Figure 2). This sustained fiscal strength reinforces our outlook for a stable credit environment and has driven positive ratings momentum, with the fourth quarter of 2024 marking the 16th consecutive quarter in which upgrades outpaced downgrades.^Footnote10

Investment takeaways: a compelling long-term outlook for munis

Current yields, strong fundamentals and historical resilience create an attractive long-term return outlook for municipal bonds. PIMCO’s five-year capital market assumptions (see Figure 3) suggest that municipals will be among the best-performing public market asset classes for tax-aware investors.

Despite concerns over potential federal spending cuts and legislative changes, we believe that the muni bond market remains attractive and that excess volatility creates more opportunities for active managers. Effectively navigating this landscape requires institutional discipline and a keen focus on policy developments and strategic security selection.

¹ TM3 MMD Interactive Data as of 11 April 2025 Return to content↩
² Lipper and J.P. Morgan as of 9 April 2025 Return to content↩
³ Taxable-equivalent yield calculation assumes a 37% federal income tax and a 3.8% Medicare investment tax. The yield to worst is the yield resulting from the most adverse set of circumstances from the investor’s point of view; the lowest of all possible yields. Return to content↩
⁴ Bloomberg as of 11 April 2025 Return to content↩
⁵ U.S. House Committee on Ways and Means as of 17 January 2025 Return to content↩
⁶ Government Finance Officers Association as of 31 January 2025 Return to content↩
⁷ U.S. Census Bureau’s Census of Governments as of 31 December 2018 Return to content↩
⁸ National Association of State Budget Officers as of 31 December 2024 Return to content↩
⁹ U.S. Census Bureau as of 31 December 2024 Return to content↩
¹⁰ Moody’s as of 31 December 2024 Return to content↩

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax.

There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.

The term “cheap” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

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