Muni Bonds Are Looking Better

Despite offering historically attractive aftertax yields, municipal bonds were one of the worst-performing sectors in the fixed-income market through the first nine months of 2025.

It’s been a risk-off year for munis: While the median total return for a strategy in the intermediate core bond and high-yield bond Morningstar Categories was 6.0% and 6.7%, respectively, through September 2025, the same measure for the muni-national long and the high-yield muni categories reflected modest gains of 1.7% and 1.3%. Those gains for munis came mostly in September, after recording losses through August 2025.

Significant amounts of new municipal-bond issuance (on pace for the largest annual total since 2017), lukewarm investor demand, and underperformance versus Treasuries all pressured prices. Additionally, narrowing credit spreads in the already crowded high-yield muni sector as we entered the year, and some deterioration in credit quality for a few larger issuers left less upside as investors ventured lower down the credit spectrum.

The muni curve began 2025 relatively flat, following several years of Federal Reserve rate hikes and monetary tightening as well as uncertainty around long-term fiscal and tax policy after the 2024 US elections. But by midyear, it had dramatically steepened. Expectations for rising inflation and interest rate cuts emerged, and the Treasury market rallied. By July, short-term muni yields had dropped off from their 2023–24 peaks, and long-term yields climbed to multiyear highs.

Retail and institutional investors alike favored shorter-dated municipal bonds for their lower volatility and attractive yields, as the long end of the curve hadn’t offered enough compensation to soak up the additional bond issuance. Indeed, in July, the spread between two-year and 30-year AAA rated municipal bonds reached 228 basis points—more than double the equivalent spread in US Treasuries. The five-year to 30-year spread neared 215 basis points, which was close to its widest level in nearly a decade.

The shift was also clear in the 30-year muni/Treasury ratio, which compares long-dated muni-bond and US Treasury yields to guide investors toward investment opportunities. The M/T ratio historically hovers near 80% to 90%, with anything over 100% suggesting that munis are a very good deal as they’re yielding more than a comparable US Treasury. The M/T ratio on the 30-year part of the curve pushed toward the higher end of its historical range, closer to 90%–95%, going into the back half of the year, indicating a good value for muni investors willing to take on some additional interest rate risk.

The Fed’s interest rate cut in mid-September 2025 prompted some flattening of the muni yield curve. Investors looking for higher income moved further out on the curve during the month, bringing yields down. Experienced municipal-bond portfolio managers still see some attractive values there, however. Indeed, for patient investors, these shifts in the muni yield curve may still present some compelling opportunities as managers often view market volatility as an excellent time to uncover attractive valuations and put money to work, especially when a certain part of the market feels unloved.

While the muni-national long category faced headwinds this year overall, that trend shifted in September. Many strategies in that category are managed by skilled teams using advanced tools and have consistently outperformed category peers in both strong and difficult muni markets. For example, Fidelity Municipal Income FHIGX and Fidelity Tax-Free Bond FTABX have fared better than most of their category rivals so far in 2025. That was also the case through 2022’s market as rates spiked and when munis sold off at the end of 2020’s turbulent first quarter. These funds also fared well over longer periods, reporting volatility-adjusted results that topped most peers over the trailing five- and 10-year periods ended Aug. 31, 2025.

These strategies provided reliable downside protection in previous bouts of market stress and solid long-term returns by leveraging robust risk tools and in-depth fundamental research.

This article first appeared in the September 2025 issue of Morningstar FundInvestor and has been updated to reflect market changes. Download a complimentary copy of FundInvestor by visiting this website.