Municipal bonds started the year on solid footing, but recent performance may have been frustrating for many investors. Year-to-date, the broad muni market is down 1.7%, compared with a 1.4% decline for U.S. Treasuries. That modest decline masks a sharper reversal: Munis were up 2.3% as of July 6, 2026, before rising rates weighed on returns. For investors who bought municipal bonds for stability and tax-advantaged income, the recent pullback may feel especially disappointing.

Under the surface, performance has varied. Shorter-term and lower-rated issuers have generally held up better than longer-term and higher-quality parts of the market. The primary reason for the recent slump has been rising Treasury yields. From February 27, 2026, the day before the Iran war began, through September 14, 2026, the 10-year Treasury yield rose from 3.9% to 5.0%, an increase of roughly 110 basis points. Over the same period, a generic index of 10-year AAA-rated¹ munis increased from 2.5% to 3.7%, an increase of roughly 120 basis points—a contributing factor to munis underperforming Treasuries during that period.

That move reflects a meaningful shift in fed funds rate expectations. Earlier in the year, markets were anticipating rate cuts in 2026; more recently, expectations have moved toward the possibility of rate hikes instead. Although the Federal Reserve directly controls short-term rates, it can also influence longer-term rates. When interest rates rise, bond prices generally fall, and longer-duration bonds tend to be more sensitive to those moves.

Given that backdrop, some investors may understandably be asking whether municipal bonds still deserve a place in their portfolios. We believe they might, particularly for those investing in a taxable account and looking for a relatively conservative investment option that produces tax-advantaged income. Municipal bonds, historically, have less volatility and default risk relative to corporate bonds of similar maturities. But the path may remain uneven, and investors should be thoughtful about where they find opportunities.

In our view, the answer depends less on the recent muni price declines and more on what role munis are meant to play. Municipal bonds are not designed to be return-maximizing assets. They are generally used to provide income, help preserve capital, and potentially reduce the tax burden for investors in higher tax brackets. When evaluated through that lens, the case for munis looks more constructive than recent performance alone might suggest.

There are two main reasons we believe municipal bonds can still make sense for more conservative investors: attractive tax-advantaged income and relatively stable credit quality. Neither eliminates short-term volatility, but both remain important longer-term supports.

We should not dismiss the recent weakness. Rising yields can create real mark-to-market losses, and those losses can be uncomfortable. However, focusing only on recent price declines can obscure one of the more important features of bonds: income. Unlike stocks, where returns depend heavily on price appreciation and dividends that can change, most municipal bonds make fixed interest payments, assuming the issuer doesn't default.

Short-term losses can feel uncomfortable, especially in an asset class many investors view as defensive. But negative performance during the year has not always translated into negative performance for the full year. Since 2004, the broad municipal bond index has been negative at some point during the year in 17 instances. In 12 of those 17 years, the index went on to post a positive total return for the full year.

This point is particularly important for investors who do not need to sell immediately. If an investor has a reasonable time horizon and owns a diversified portfolio of higher-quality bonds or bond funds, the income generated over time may help offset some of the price volatility that occurs when rates move higher.

While past performance is no guarantee of future results, history illustrates why time in the market can matter. The longer an investor remains invested, the greater the potential for coupon income to build and help offset periods of negative price performance.

Higher yields have caused prices to move lower and total returns to suffer, but higher yields also improve the income backdrop going forward. Historically, coupon income has been the largest contributor to muni total returns over time and has helped offset negative price returns. For example, over the past 30 years, the price return for the Bloomberg Municipal Bond Index has been negative in 14 years. However, coupon income has always been positive and helped offset those declines, such that the index had a negative total return in only four instances since 1996.

That is why we think the recent rise in yields is a double-edged sword. It has hurt recent returns, but it has also improved the income available today. For investors adding new money, reinvesting coupon income, or gradually building a muni allocation, higher starting yields can also be a benefit rather than only a problem.

Higher yields may not only be a positive for returns going forward; they can also be a welcome sign for investors focused on the income that munis pay. The yield to worst (the lowest possible yield an investor can receive from a callable bond, barring default) of the Bloomberg Municipal Bond Index was about 4.3% as of September 10, 2026. For an investor in the top federal tax bracket, that's roughly equivalent to a 7.2% yield on a fully taxable bond before considering state income taxes. Relative to other fixed income investments, we believe that might be attractive given the potential risks. There have been instances where munis only made sense for investors in the top tax brackets, but that isn't necessarily the case today—especially after considering the risks.

Tax-equivalent yield is a useful way to compare munis with taxable bonds. Because municipal bond interest is generally exempt from federal income taxes, and may also be exempt from state and local taxes for in-state residents, the stated yield on a muni can understate its value to a taxable investor. The higher an investor's tax rate, the more valuable that tax exemption generally becomes.

When munis are compared to corporate bonds, an investor may only need to be in the 22% or above federal tax bracket for the after-tax yield on a corporate bond to equal that of a generic muni bond. This threshold fluctuates over time, so we generally suggest that investors use it as a starting point rather than as an absolute cutoff. State taxes, the investor's holding period, credit quality, and liquidity all matter as well.

We believe we are past the peak in municipal credit quality nationally, but the backdrop remains favorable. We don't expect economic growth to substantially slow, which should support state and local government tax revenues. Many states also continue to benefit from robust reserves built after the onset of the COVID-19 pandemic. For example, the average state can run off their rainy day funds for approximately 48 days. This is down from a peak of above 54 days but well above its low. A rainy day fund is akin to a savings account. If a state experiences a slowdown in revenues, they can generally tap into those liquidity sources to help offset the decline.

Those liquidity cushions matter. If the economy slows and tax revenues weaken, state and local governments may be able to draw on reserves to help offset declines. The starting point also matters: The muni market remains highly rated on average, and even if there were broad credit downgrades, which is not our base case, the market would likely remain highly rated overall.

That said, credit quality can vary substantially by issuer and sector. Essential-service revenue bonds, general obligation bonds, and certain highly rated state and local issuers can have different risk profiles than more economically sensitive projects. Investors should avoid assuming that all munis carry the same risk simply because they receive similar tax treatment.

That does not mean the broad market is free of headwinds. In our view, one key issue facing the muni market is whether demand can absorb elevated levels of supply.

Year-to-date through Sept. 4, municipalities have issued nearly $430 billion of tax-exempt debt—the highest amount for the same period in Bloomberg data going back to 2010. Given ongoing infrastructure needs and reduced post-pandemic federal aid, issuance may remain elevated in the near term.

Municipalities are issuing debt at a record pace for several reasons. First, infrastructure costs, which many muni bonds are issued to fund, are higher after a prolonged period of elevated inflation and higher yields. Second, the fiscal aid granted to many states and local governments after the onset of COVID-19 has largely been spent. Some of that shortfall is being replaced with bond issuance. These factors are unlikely to change quickly, suggesting issuance may remain elevated.

For investors, the important takeaway is that the muni market may need sustained demand to absorb continued issuance. If demand falters, yields may have to move higher, and prices lower, to attract buyers and support returns.

One factor that may weigh on demand is the level of muni yields relative to Treasuries. A common metric for gauging relative value is the muni-to-Treasury ratio, also known as the municipals-over-bonds (MOB) spread. It compares the yield on a generic AAA-rated muni with the yield on a comparable Treasury bond before taxes.

Ratios for munis with maturities of three years or less are in the upper 50s or low 60s. As investors move further out the maturity spectrum, ratios increase and are near the highs of the year.

This matters because the muni market is largely dominated by retail investors, many of whom prefer staying short term or not moving too far out on the yield curve. For munis with maturities under five years, yields are near the level where an investor would need to be subject to the maximum tax rate for the yield on a generic AAA muni to equal that of a comparable Treasury bond after taxes. For example, the two-year ratio is about 60%, meaning an investor would need a tax rate of about 40% to make a generic AAA two-year muni equal to a two-year Treasury on a tax-adjusted basis. The top federal tax rate is 37%, plus a 3.8% Net Investment Income Tax (NIIT) tax for certain investors, for a combined rate of 40.8%.

Duration is one important lever that investors can control. Longer-duration bonds are more sensitive to changes in interest rates, which can help when rates fall, but hurt when rates rise. Investors who are concerned about additional rate volatility may want to avoid extending too far beyond their investment horizon.

We generally suggest slightly shorter-than-benchmark duration due to the potential for higher yields and interest-rate volatility. For muni investors, a useful starting point is the duration of the Bloomberg Municipal Bond Index, which is about 6.4 years. Investors may want to target a duration modestly below that level, depending on their financial situation, time horizon, and risk tolerance. For investors focused on income, one positive is that yields, especially for shorter-term munis, have moved higher over the past six months. That means investors may not need to extend too far out the maturity spectrum to generate attractive tax-advantaged income.

Higher yields can make riskier parts of the muni market look more appealing, but investors should ask what risks they are being paid to take. A higher yield may reflect longer duration, weaker credit quality, lower liquidity, or a combination of all three. For investors who rely on munis for stability, the goal might be to earn reasonable income without taking risks that are inconsistent with the role munis are meant to play in the portfolio.

Recent muni performance has been disappointing, but we do not think it changes the longer-term case for the asset class. Municipal bonds can still offer attractive tax-advantaged income and relatively stable credit quality for investors who understand the risks and can look beyond short-term price volatility. The recent move higher in yields has made prices weaker, but it has also improved the income available to investors today.

Given higher yields, elevated supply, and uncertainty around demand, we believe investors should stay disciplined. That might mean avoiding reaching too far for yield in either lower-rated or longer-term bonds, considering a slightly shorter-than-benchmark duration, and focusing on highly rated issuers.