The S&P Municipal Index (Municipal Index) returned 2.25% in the second quarter and 2.07% year to date, overcoming record levels of supply and geopolitical uncertainty to rank among the top performers across the fixed income universe. Returns were driven by a combination of price return and coupon return as municipal bonds benefited from lower rates during the quarter.
The municipal yield curve flattened by 21 basis points (bps) to 1.84% during the quarter, as measured by the spread between 2- and 30-year rates. Short-term yields declined by 4-8 bps, while long-term yields declined by 25-34 bps. The shift in municipal term structure indicates a decreased risk premium for interest rates. By comparison, the U.S. Treasury (UST) yield curve flattened to a greater degree, falling 33 bps to 0.78% but as a result of short-term rates rising more than long-term rates.
Municipal bonds with maturities or call features greater than 10 years outperformed short-term maturities as yields fell most for longer-dated obligations, which are more price-sensitive to a decline in interest rates. Among quality cohorts, A-rated and BBB-rated bonds outperformed higher-rated bonds, benefiting from higher relative spread and modest spread tightening.
In comparison with taxable fixed income sectors, the Municipal Index outperformed the Bloomberg U.S. Treasury Index by 193 bps in the second quarter, as municipal yields fell while UST yields increased. Municipals also outperformed the Bloomberg U.S. Aggregate Index and Bloomberg U.S. Corporate Index by 158 and 85 bps, respectively, despite 20 bps of spread tightening in corporate bonds.
From a technical perspective, second-quarter municipal bond issuance (supply) of $172 billion brought year-to-date issuance to $309 billion, a 10% increase compared to the first six months of 2025 and on pace for a record level of calendar-year issuance. The increased supply has been well digested as evidenced by resilient municipal performance, with investor demand for municipals remaining strong among retail investors and mutual funds — the largest buyers of municipal bonds. Municipal mutual funds experienced net inflows of $12 billion during the quarter, which helped to offset the gap between elevated levels of supply and reinvestment demand from coupon payments, calls and maturities.
Tax-exempt municipal valuations
Across maturities, municipal valuations relative to USTs were richer by 6-7% on a quarter-over-quarter (q/q) basis, an unsurprising development given the level of outperformance. All of the measured Municipal-to-Treasury (MT) ratios are now trading below their respective one-year averages.
Compared to taxable alternatives, tax-exempt municipal bonds remain attractive on a tax-equivalent basis, 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 112% of the 4.45% yield offered by a 10-year UST, down from 122% at the end of last quarter. For investors with a tax rate of 40.8%, tax-equivalent MT ratios are above 100% across the yield curve, with a greater advantage in long-term bonds. Meanwhile, investors with a federal tax rate of 37% begin to see value from the tax exemption for maturities greater than seven years, while those with a tax rate of 32% must extend beyond 12 years as reflected by tax-equivalent MT ratios above 100%.
Taxable municipals underperformed tax-exempt counterparts
The S&P Taxable Municipal Bond Index (Taxable Municipals) returned 0.86% in the second quarter, and underperformed tax-exempt municipals by 1.39%. Taxable municipals also underperformed the Bloomberg U.S. Corporate Index by 53 bps for the quarter, but have outperformed by 56 bps year to date due to a greater degree of relative spread tightening. 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 four and 20 years. Given the competitive yield landscape and our expectation for stable taxable issuance for the remainder of 2026, we believe supply-side technicals remain supportive of valuations.
Municipal credit review
Throughout most of the second quarter, municipal credit spreads retraced losses experienced in the prior quarter as geopolitical issues influenced economic measures. This activity was broadly consistent with corporate markets during the same period. Credit spreads declined across the investment-grade spectrum, most notably for BBB- and A-rated bonds. For both municipals and corporates, credit pricing more closely reflects pre-conflict levels, and therefore has discounted any long-term effects from the heightened geopolitical instability.
During the second quarter, municipal fundamentals remained broadly stable, supported by reserve levels and a resilient economy, but issuer dispersion became more apparent. The Health Care sector continued to show the clearest signs of stress, with multiple hospital downgrades tied to weak liquidity, margin pressure, leverage and Medicaid/state-funding exposure. State ratings remained largely high-grade, although the state of Maryland’s move to a negative outlook by S&P (in May 2026) demonstrated that even top-rated credits face downward rating pressure. Tax policy remained supportive during the quarter, with the municipal bond exemption preserved by the Government Finance Officers Association under the One Big Beautiful Bill.
In what we view as more of an idiosyncratic development, in April, S&P downgraded the city of New Orleans by one notch to BBB+ and provided a negative outlook. While the city has received an influx of $100 million from the sale of nine years’ worth of lease payments for Caesars Casino, it continues to rely on borrowing to fund ongoing expenses. In late June, the city council approved a $110 million bond deal for cash flow purposes, indicating that the city is still in search of additional sources of recurring revenues along with a reduction in expenses.
Looking ahead
Recession risk continues to be subdued in our view; the PNC Economics team increased its forecasts for economic growth in 2026 and into 2027, provided oil prices remain below $130 per barrel. The increase is supported by improving labor market conditions and resilient consumer spending despite the recent oil price shock. This combination of factors has led to decreased expectations for rate cuts in 2026, with the team forecasting no rate cuts through year end as risks to price stability and employment have become more balanced.
Resilience in the second quarter has led to richer valuations across the municipal market, both within the municipal universe and relative to taxable fixed income sectors. As such, we believe the path to additional outperformance will become more challenging, reinforcing our view that income will be the primary driver of municipal returns over the next six to 12 months. Year to date, this dynamic has been in play for the Municipal Index as income has contributed 88% of this year’s 2.07% total return. Additionally, while record levels of supply have been well digested via above-trend investor demand, any pullback in demand amid continued high issuance could present a technical imbalance that would likely weigh on prices. Overall, we view credit pricing as reflective of strong fundamental conditions and high levels of financial reserves. We continue to believe a measured approach to credit risk is prudent, given our expectation for flat to potentially wider credit spreads through year end.
Despite the decline in municipal yields over the course of the second quarter, the S&P Municipal Index yield remained above the 74th percentile of its 10-year range. This reflects much improved yields after years of zero-interest-rate and pandemic-era monetary policy, with value from the tax-exemption still to be found for many tax-sensitive investors.
Key theme recap
- The Municipal Index returned 2.25% in the second quarter and outperformed comparable taxable indices on a quarterly and year-to-date basis.
- The municipal yield curve flattened as long-term yields fell more than short-term yields, which indicated a decreased risk premium for interest rates.
- Municipal valuations became more expensive relative to USTs on a maturity-matched basis for the quarter.
- While municipal fundamentals remain strong, we believe 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 believe municipal yields offer a compelling option for tax-sensitive investors relative to taxable alternatives, particularly for longer-dated bonds.
