The S&P Municipal Index (Municipal Index) returned 1.55% in the fourth quarter, bringing its calendar year total return to 4.26%. Returns were primarily driven by coupon income amid modest price appreciation. Longer-duration municipal assets outperformed for the quarter and year, as investors took advantage of attractive tax-equivalent yields relative to shorter maturities and taxable alternatives. A more dovish approach from the Federal Reserve (Fed) also served as a tailwind, with policy rates cut from 4.50% to 3.75% in the second half of the year. The market is currently pricing in two additional cuts in 2026, reflecting a balance between progress made in reducing inflation toward their target of 2% and maintaining labor market strength.
For the quarter, municipal yields were mixed across the yield curve. Short-term yields increased, while longer-term yields decreased, flattening the yield curve by 9 basis points (bps), as measured by the spread between 2- and 30-year rates. The shift in municipal term structure indicated a decreased risk premium for interest rates. In contrast, the U.S. Treasury (UST) curve steepened as the spread between 2- and 30-year yields increased 27 bps to 1.38%. Municipal bonds with maturities beyond 10 years outperformed shorter-term maturities as yields declined most for long-term obligations, which are the most price-sensitive to changes in interest rates.
Relative to taxable fixed income sectors, the Municipal Index outperformed the Bloomberg UST Index by 65 bps in the fourth quarter as municipal yields decreased more than USTs for maturities beyond seven years. Municipals also outperformed the Bloomberg U.S. Aggregate and Bloomberg U.S. Corporate indices by 45 bps and 72 bps, respectively, similarly driven by the relative change in interest rates. Among quality cohorts, A-rated and BBB-rated bonds outperformed higher-quality bonds, benefiting from stable spreads and higher relative yields.
From a technical perspective, investor demand for municipals remained strong, particularly among retail investors and mutual funds, the largest natural buyers of municipal bonds. Municipal mutual funds experienced net inflows of $1.9 billion during the quarter and $13.5 billion for the year. On the supply side, municipal bond issuance of $136 billion increased by 7% compared to fourth quarter 2024. Issuance in 2025 set a calendar year record, up 12% compared to 2024, but the glut was well digested by the market. The increase was consistent in both tax-exempt and taxable municipal issuance. Approximately 6% of all municipal bonds issued in 2025 have been taxable, similar to 2024.
Tax-exempt municipal valuations
Municipal valuations relative to USTs were mixed across the yield curve quarter over quarter (q/q). The 10- and 30-year Municipal-to-Treasury (MT) ratios declined, falling by 4.4% and 2.4%, respectively, while the 2- and 5-year MT ratios improved by 2.5% and 5.1%, respectively. Despite the shift in relative valuations q/q, the 2- and 10-year ratios were little changed for the year, while 30-year ratios improved by 6%. The 5-, 10- and 30-year MT ratios are now below their respective 1-year averages.
Tax-exempt municipal bonds remain attractive on a tax-equivalent basis versus taxable alternatives, particularly for longer maturities. Assuming an estimated federal tax rate of 40.8% (37% maximum federal income tax level and 3.8% Medicare tax that may apply to some taxpayers), the tax-equivalent yield of a 10-year AAA-rated municipal bond now offers 111% of the 4.19% yield offered by the 10-year UST, down from 119% 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 rations above 100% for maturities 11 years and beyond.
Taxable municipals underperformed tax-exempt
The S&P Taxable Municipal Bond Index (Taxable Municipals) returned 1.09% in the fourth quarter, underperforming tax-exempt municipals by 46 bps but outperforming by 341 bps for the year. Conversely, taxable municipals outperformed the Bloomberg U.S. Corporate Index by 25 bps for the quarter, but underperformed by 10 bps for the year, reflecting a greater degree of spread compression in corporate bonds. As of quarter-end, A-rated taxable municipal bond yields are largely in line with A-rated corporates across the yield curve. We believe supply-side technicals remain supportive of valuations given the landscape of competitive yields and our expectation for stable taxable issuance in the year ahead.
Municipal credit review
Municipal credit investors felt the weight of record issuance, $580 billion, in 2025. While credit spreads remained generally stable in the fourth quarter, the result for the full year was 5-15 bps of widening. BBB-rated bonds widened most, resulting in underperformance relative to A- and AA-rated bonds. By comparison, corporate credit pricing remained stable for the year, helping to drive outperformance of corporate bonds over municipals.
Despite the modest underperformance of credit for the full year, there was a notable positive credit rating in the fourth quarter as the State of Illinois received an upgrade to A2 from Moody’s in October. The agency cited improved financial metrics, including more robust liquidity, for the lowest rated state. Conversely, Moody’s, S&P and Fitch all downgraded the City of New Orleans and maintained negative outlooks going forward. The city is facing a cash flow crunch after disclosing the need to borrow state money to meet higher-than-expected payroll costs. The Louisiana State Bond Commission approved the loan but requires state oversight of city finances in return.
More broadly, municipal finances remain strong, supported by continued economic growth. While states increased their rainy-day fund balances, rainy-day funds as a percentage of expenditures were lower year over year according to the National Association of State Budget Officers, reflecting a faster increase in expenditures than reserves in 2025. Most states have stronger rainy-day funds than they did prior to COVID-19, with continued improvement expected in 2026.
Looking ahead
Worth monitoring in 2026 and beyond are the effects of the One Big Beautiful Bill Act (OBBBA). Passed in 2025, the act included several provisions likely to impact municipal bonds. The increased state and local tax deduction from $10,000 to $40,000 could marginally weigh on investor demand for municipal bonds in high-tax states like California, New York and New Jersey. The municipal hospital sector will also likely experience impacts from the Act as it outlines $1.1 trillion in healthcare cuts set to take place in 2027. However, impacts will differ materially by obligor. Hospitals that serve a large Medicaid population and are most reliant on supplemental payments face the most challenges. These upcoming changes strengthen our preference for large hospitals that are well-funded and serve markets with favorable demographics.
Looking ahead to 2026, we believe a measured approach to credit risk is prudent given our expectation for flat to potentially wider credit spreads over the course of the next twelve months. This exhibits our view that credit pricing is reflective of the currently strong fundamental conditions and the expectation for continued economic growth. As such, we expect income, followed by duration, to be the primary driver of returns in 2026 as the market grapples with the Fed’s shift in interest rate policy. An improvement in relative valuations and attractive absolute yields offer value for tax-sensitive investors, in our view, with the S&P Municipal Index yield in the 78th percentile of its 10-year range.
