Recent market swings, affected by headline news on tariffs, had reverberations all the way to the municipal bond market. While several political impacts are making their mark on muni issues, muni bond investors have become especially concerned about two risks. First, muni yields moved in the opposite direction of Treasuries, causing a dislocation. Second, some policymakers have questioned the future of the muni tax-exemption. While these considerations may seem troubling, we remain constructive on the muni market, and amid equity volatility, expect munis to provide strong diversification.

Volatility hits the market

Munis struggled in the first quarter, even before the April tariff announcements. In fact, there was a dislocation between Treasuries and munis, as their yields – and consequently returns – moved in opposite directions. In the first quarter, Treasuries (represented by the Bloomberg U.S. Treasury Index) returned 2.92% and munis (represented by the Bloomberg Municipal Bond Index) returned -0.22. Typically, muni yields and returns are correlated with those of Treasuries.

This dislocation continued into April. Treasury and broad bond market (represented by the Bloomberg U.S. Aggregate Index) returns were positive in April, while munis declined. Munis returned -0.81%, lagging both Treasury and broad bond market returns by -144 basis points (bps) and -120 bps, respectively. 

We see three major factors to consider when analyzing the muni volatility experienced this year:
 

1. Counterparties (a partner in a financial transaction) have been stepping away due to overall financial market uncertainty. Financial institutions usually play an important role in the muni market turmoil by acting as a liquidity provider and market buffer. Increased risk has led them to step aside in recent weeks.
   
2. Exchange-traded fund (ETF) redemptions. We’ve seen an uptick of ETF redemptions, which tend to happen in larger swaths. The muni market acts as a flow market, so outflow cycles meaningfully affect muni market results. We see this as a temporary move and not one likely to escalate and lead to a broader sell-off.
3. Higher grade munis are more liquid and first out the door. This supply hitting the market has led to a more adverse price impact to high-grade munis in the short term.
    

Longer term concern is that this market movement causes retail investors to move to cash and we see an investor-led outflow cycle. These tend to be longer in nature and could lead to further weakening. The muni market is 66% owned by retail investors (45% directly and 21% in muni bond funds), so changes in their behavior could have meaningful impact on the market.

Uncertainty remains high given a lack of clarity on policy and individual headlines often heightening volatility. Recession risks appear to be rising meaningfully even as inflationary pressures may also be building, creating potential for a stagflationary shock (a period of rising unemployment, low economic growth and rising prices).

Moreover, we expect federal spending cuts, particularly in the education and healthcare sectors, to have a more notable and immediate impact on municipal credits compared to tariffs.

Our portfolio managers are maintaining up-in-quality postures and neutral-to-overweight duration stances. As valuations come under pressure and volatility persists, we believe our portfolios are well-positioned to take advantage of dislocations and attractive opportunities.

Will the tax exemption expire?

Nearly 75% of the infrastructure in the U.S. is financed by municipal (muni) bonds. Tax-exemption for muni bonds dates back to 1913. As a pillar of the U.S. financial system, muni bonds allow state and local governments to fund, with low-cost borrowing, essential services, including roads, sewer systems, public education, parks, hospitals and more. Funding is plentiful in part because investors who purchase the debt of these municipalities are exempt from paying federal income tax on the income they provide. Munis are also a relative safe haven, with a lower default rate than global corporate bonds. As a result, muni bonds can be an attractive asset class for income investors looking for relatively low-risk tax-efficient investment strategies.

Which brings us to the first worry plaguing some investors: the expiration of the Tax Cuts and Jobs Act (TCJA). With a budget hole to fill, there have been some whispers of removing the tax-exemption status of munis. In January, a U.S. House Ways and Means Committee proposal included the line, “eliminate exclusion of interest on state and local bonds.” These nine words triggered some unease, and served as part of the reason why the muni market cheapened relative to the taxable bond market in the first quarter of this year. The proposal instilled a seed of doubt in investors, and caused issuers to bring deals earlier than they might have otherwise, resulting in an increase in supply of muni bonds. A total elimination of the tax-exemption could lead to higher borrowing costs, strained budgets, changes to essential services and other material impacts. In new developments, the full, updated draft of the U.S. House tax committee's reconciliation bill released on May 12 did not seek to remove the broad muni tax exemption, but did contain a few provisions that could have a negative impact on some sectors, if adopted.

Overall, we view the removal of the tax exemption as a very unlikely scenario for a few reasons. First, it would be very hard — or nearly impossible — to implement retroactively on existing municipal issues. Thus, if implemented, it would likely be on a “go-forward” basis only for new issues. The way budget math works, this would amount in a relatively tiny deficit reduction.

Second, while the U.S. House budget document estimates that eliminating the exemption would add $250 billion over 10 years, the Public Finance Network (PFN) says it would cost cities and states $824 billion in higher borrowing costs. As such, this would become a bipartisan issue. To supplement those costs, state and local governments would be forced to raise taxes. According to the PFN, this could result in a $6,555 tax and rate increase for individual households over the next 10 years. 

Third, smaller issuers in the municipal market could also lose market access. Small issuers ($5 million and less) are 25% of the total muni market. For example, a school district looking to finance construction of a new school for $10 million could face sharply higher debt costs when competing with much larger corporate issuers, essentially pricing them out of the market. 

Although we don’t expect any change, if any change were to occur we believe an elimination in exemption status at the sub-sector level could occur in segments like private-activity bonds (PABs). These were previously considered for elimination in some versions of the TCJA bill in 2017.

Keep watch and remain invested

We believe in remaining invested in the market is the best strategy for long-term success. Fundamentals in the muni market remain solid, and this volatility has been led more by liquidity and external shocks than deteriorating fundamentals. Additionally, Muni/Treasury ratios (which compare muni bond yields to U.S. Treasury yields), are at their most attractive levels since 2022. Investors willing to look past short-term volatility could see an attractive entry point into muni bonds.

Munis can provide diversification when recessionary risk rises. In fact, munis can possibly provide stronger diversification than most taxable bonds and equities, especially since so much repricing in these asset classes have already occurred.

Our team of investment professionals keeps a close eye on developments in the muni market. We continue to believe that investors seeking extra income from tax-exempt munis can benefit from owning this asset class.

For more information on our municipal bond funds, visit The Tax-Exempt Bond Fund of America, American Funds Short-Term Tax-Exempt Bond Fund, Limited Term Tax-Exempt Bond Fund of America or American High-Income Municipal Bond Fund. For those interested in state-specific muni bond funds, which may offer income exempt from state taxes, visit The Tax-Exempt Fund of California or American Funds Tax-Exempt Fund of New York. Exchange-traded funds (ETFs) are also available; for more information, visit CGMU - Capital Group Municipal Income ETF, CGSM - Capital Group Short Duration Municipal Income ETF or CGHM - Capital Group Municipal High-Income ETF.