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Is May the month for Munis?

5/9/2025

Chad Farrington

Co-Head, DWS Municipal Bond Portfolio Management

Tax-exempt yields are close to the highest levels in more than a decade.
Valuations appear attractive versus U.S. Treasuries on an after-tax basis.
Muni yield curve is much steeper than U.S. Treasury curve, potentially compensating investors for the extra duration* of long maturity bonds.

While the old adage used in the equity markets, ‘Sell in May and go away’, may be of consideration this time of year, the current dynamics in the municipal market may actually present an opportunity to take advantage of attractive tax-exempt yields before summer hits. Recent municipal market performance has been underwhelming due at least in part to a demand/supply imbalance. Supply is on pace to beat the record year of 2024. Cash has been flowing out of mutual funds for most of the past two months. Money from coupons and bonds reaching maturity (i.e, maturity money) that are available for reinvestment was low in March and April. In our view, strong separately managed account (SMA)^[1] demand for bonds with a maturity of less than 15 years results in a municipal yield curve that is steeper than the U.S. Treasury curve, may effectively compensate investors for taking interest rate risk for buying bonds with longer dated maturities. Given all these headwinds and dynamics, now may be an attractive time to buy tax-exempt municipal bonds.

As of April 30, tax-exempt yields are near the highest levels in more than a decade and very attractive when compared to other fixed income segments. For an individual in the highest tax bracket, the 30-year yield-to-worst of the Bloomberg U.S. Municipal Bond Index of 4.06% far exceeds the 2.77% after-tax yield of the 30-year U.S. Treasury. The Bloomberg U.S. Corporate High Yield Index yield-to-worst of 7.9% looks pleasing until you consider taxes, which knocks it down to 4.68%. Comparing this the Bloomberg U.S. Municipal Index which reflects AA rated tax-exempt bonds, investors can achieve similar yields less the credit risk that accompanies corporate high yield bonds that have lower credit quality ratings.

*After tax assuming 40.8% tax rate
Source: Bloomberg as of April 30, 2025
It is not possible to invest directly in an index

Through the end of April, heavy supply has led to underperformance of municipal bonds versus other fixed income sectors. This underperformance can be measured by the Municipal to Treasury ratio (M/T ratio) which compares the yield of municipal bonds to the yield of U.S. Treasury bonds. The increased supply has led to cheaper ratios relative to U.S. Treasuries. Currently, tax-exempt ratios versus U.S. Treasuries across the yield curve are cheaper than one-, three-, and five-year averages. The 30-year tax exempt yield was 9% of the 30-year Treasury as of April 30, 2025. The three- and five-year averages have been closer to 89%.

Investors have the option to reinvest the coupon payments they receive each month, and can also look to reinvest the proceeds of their bond once it fully matures. This is an important dynamic that can demonstrate investor demand of the muni bonds. At DWS we have seen that natural flows from coupon and maturity payments are forecasted to return in May after two of the lowest months of the year. Reinvestment in the June-August period is projected to be close to 15% greater than the amount in the preceding 4 months. As we head into summer, this could be a tailwind and may lead to outperformance versus other fixed income alternatives.

Source: Bloomberg as of April 30, 2025

An investor in the municipal market can potentially earn greater yield by moving out longer on the yield curve than a U.S. Treasury investor on an after-tax basis. While moving from two to ten years on the U.S. Treasury curve may likely provide more yield than investing in the municipal market, once you go beyond 10 years, the yield advantage shifts in favor of the municipal market. The yield differential between a 30-year U.S. Treasury bond and a 10-year U.S. Treasury note is 50 basis points. In the municipal bond market, the yield differential between the 10- and 30-year maturity is two times that amount. This dynamic is really a function of the sources of investor demand for different parts of the municipal curve. For maturities earlier than 15 years, there appears to be steady, strong demand from the growing separately managed account business. Beyond 15 years, demand appears more prevalent among open-ended mutual funds and the small, but growing, ETF segment. While flows were positive for the first two months of 2025, they turned negative in March and April. When combined with heavy new issuance, longer maturity rates moved higher than shorter maturity rates, steepening the yield curve.

Source: Bloomberg as of April 30, 2025

Although inflationary concerns remain, fears of economic weakness appear to be tilting policy bias toward rate cuts as the Federal Funds futures market is currently pricing at least two cuts before year end. In our view, recent market weakness due to elevated supply and fund outflows have increased yields, steepened the tax-exempt municipal yield curve, and increased the attractiveness of municipal bonds relative to taxable alternatives. This potentially creates a timely opportunity for investors across the spectrum to invest; for investors in high-income tax brackets, they may benefit more-so from the tax efficiency that municipal bonds provide in potentially enhancing portfolio returns.

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*Duration is the measure of price sensitivity to changes in interest rtes. In general, the higher the duration, the more a bond’s price will drop as interest rates rise. This also indicates a higher level of interest rate risk.

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Is May the month for Munis?

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