The S&P Municipal Index (Municipal Index) returned -0.18% in the first quarter as geopolitical conflict in the Middle East drove interest rates higher across fixed income markets. Returns were primarily driven by duration as falling prices more than offset coupon income during the quarter. Shorter-duration municipal assets outperformed due to lower price sensitivity to changes in interest rates. The Federal Reserve (Fed)’s modestly dovish approach to monetary policy throughout the past 18 months has recently come under pressure as higher oil prices stemming from the conflict impact the inflation outlook. The market is currently pricing in zero fed funds rate cuts for 2026, which comes in contrast to the two cuts that investors were anticipating just a few months ago.
For the quarter, municipal yields were mixed across the yield curve. Short-term yields were little changed while longer-term yields increased and steepened the yield curve by 20 basis points (bps), as measured by the spread between 2- and 30-year rates. The shift in municipal term structure indicated an increased risk premium for interest rates. In contrast, the U.S. Treasury (UST) curve flattened as the spread between 2- and 30-year yields decreased 27 bps to 1.11%. Municipal bonds with maturities under three years outperformed longer-term maturities as yields increased least for short-term obligations, which are also the least price-sensitive to changes in interest rates.
Relative to taxable fixed income sectors, the Municipal Index underperformed the Bloomberg U.S. Treasury Index by 14 bps in the first quarter, as municipal yields increased more than similar duration USTs for maturities beyond five years. Municipals also underperformed the Bloomberg U.S. Aggregate Index by 13 bps, likewise driven by the relative change in interest rates. However, municipals outperformed the Bloomberg U.S. Corporate Index by 36 bps as corporate credit spreads widened from decade-long lows. Among quality cohorts, A-rated and BBB-rated bonds outperformed higher-quality bonds as higher relative yields served to offset the impact of rising interest rates.
From a technical perspective, investor demand for municipals remained strong, particularly among retail investors and mutual funds, the largest buyers of municipal bonds. Municipal mutual funds experienced net inflows of $16 billion during the quarter, more than double the prior three-year, first-quarter average. On the supply side, municipal bond issuance of $137 billion increased by 15% compared to first quarter 2025, and 2025 was a record calendar year for new issuance. The increase was consistent in both tax-exempt and taxable municipal issuance. Approximately 5% of all municipal bonds issued in 2026 have been taxable, a similar level to 2025.
Tax-exempt municipal valuations
Municipal valuations relative to USTs were mixed across the yield curve on a quarter-over-quarter (q/q) basis. The 10-year Municipal-to-Treasury (MT) ratio improved most, rising 7%, while 5- and 30-year ratios improved between 3-4%. In contrast, the 2-year MT ratio declined 5.0% as short-term municipal yields only increased modestly relative to USTs. The shift in relative valuations q/q helped push the 5-, 10- and 30-year MT ratios above their respective 1-year averages.
Tax-exempt municipal bonds remain attractive on a tax-equivalent basis compared to taxable alternatives, particularly for longer maturities. Assuming an estimated federal tax rate of 40.8% (37% maximum federal income tax level plus 3.8% Medicare tax that may apply to some taxpayers), the tax-equivalent yield of a 10-year AAA-rated municipal bond now offers 122% of the 4.33% yield offered by a 10-year UST, up from 111% at the end of last quarter.
For investors with a tax rate of 40.8% and 37%, tax-equivalent MT ratios are above 100% across the yield curve, with more advantage in long-term bonds. Investors with a lower tax rate of 32% can also find value in tax-exempt municipals, reflected by tax-equivalent MT ratios above 100% for maturities of five years and beyond.
Taxable municipals outperformed tax-exempt counterparts
The S&P Taxable Municipal Bond Index (Taxable Municipals) returned 0.55% in the first quarter, outperforming tax-exempt municipals by 0.72%. Taxable municipals also outperformed the Bloomberg U.S. Corporate Index by 109 bps for the quarter and reflected greater spread widening in corporate bonds. The shift in relative spreads has left A-rated taxable municipal bond yields approximately 10-20 bps lower than similar-duration corporates for maturities between three and 20 years. We believe supply-side technicals remain supportive of valuations given the landscape of competitive yields and our expectation for stable taxable issuance in 2026.
Municipal credit review
While investors started the first quarter with expectations of additional monetary policy easing and slowing economic growth, the start of the Iran conflict in late February ignited a rise in rates as higher oil prices raised inflation expectations. Following the shift in investor concern from assessing recession risk to risks of inflation and heavy municipal supply, relative credit spreads widened in the latter part of the quarter. This widening occurred mainly in A- and AA-rated bonds, while low-grade spreads remained steady as investors sought out yield. Corporate credit risk also reversed trend during the quarter as spreads widened from recent lows.
Recent federal policy initiatives are beginning to filter through the Healthcare sector. The enhanced Affordable Care Act subsidies expired at the end of 2025, leading to a notable rise in the uninsured population during the first quarter. With premiums becoming more expensive, approximately 9% of enrollees have opted out of insurance. In our view, nonprofit hospitals are likely to experience an increase in uncompensated care, pressuring operating margins going forward.
While the overall credit environment in the municipal sector is stable, there are signs of budgetary stress that emerged during the quarter. In February, Moody’s Ratings (Moody’s) downgraded the City of New Orleans from A3 to Baa2, following the city’s announcement that it was facing a large deficit and sought state approval for a loan to address near-term cash flow issues. In March, Moody's affirmed New York City’s Aa2 rating but revised its outlook from stable to negative, citing updated projections of larger outyear budget gaps. The change points to a slightly more constrained financial position, although New York City is expected to maintain their high-grade rating, supported by its large and diverse economic base.
Looking ahead
After a relatively sanguine start to the year, March brought notable volatility in fixed income markets, driven by inflation concerns resulting from geopolitical conflict in the Middle East and its impact on oil prices. While municipal fundamentals are relatively insulated in the short term, macroeconomic trends can have an impact on municipal finances in the long run. While recession risk has risen, the PNC Economics team forecasts continued economic growth through 2026 provided oil prices remain below $130 per barrel, albeit at a slower pace than previously anticipated. This slower growth and higher inflation dynamic has also shifted our expectation for rate cuts for the remainder of 2026, with the Fed now anticipated to remain on hold through year-end.
The recent increase in volatility reinforces our view that taking a more measured approach to credit risk is prudent given our expectation for flat to potentially wider credit spreads over the course of the next 12 months. We also believe that credit pricing is reflective of the currently strong fundamental conditions and high levels of financial reserves. As such, we expect income, followed by duration, to be the primary drivers of returns for the remainder of 2026, with less consensus around the path for Fed policy, which largely depends on the duration and depth of the Middle East conflict.
Overall, first-quarter volatility has led to an improvement in the relative valuations and absolute yields within the municipal universe. The S&P Municipal Index yield is now in the 87th percentile of its 10-year range, which we believe illustrates the value municipal bonds can offer tax-sensitive investors.
