Municipal bonds have been making headlines in 2025, and investors are asking questions about how proposed policy changes and macroeconomic shifts could impact the municipal market. Our team is closely monitoring contemplated policies that could affect the relative attractiveness and credit quality of tax-exempt investments. While some specific credits have not fully priced in policy risk, broadly, municipal credit continues to have strong underlying fundamentals and attractive tax-adjusted yields. Indeed, municipal bonds are now at their cheapest levels relative to U.S. Treasuries in over a year.

Could municipal bonds lose their tax-exempt status?

Changes to the tax-exempt status of municipal bonds are not included in the House of Representatives Ways and Means Committee’s proposed tax bill. However, negotiations between the House and Senate may lead to summer headlines if lawmakers need to find sources of revenue to pay for tax cuts. Our base case remains that the exemption is unlikely to be eliminated completely because that would increase the cost of building infrastructure; borrowing could only be done in the taxable market at higher borrowing rates, increasing the cost to U.S. citizens through higher taxes. Essentially, all citizens benefit from the tax exemption that helps finance infrastructure at the local level, and eliminating it could negatively impact economic growth.

If future issuance becomes taxable, we would expect existing debt to remain tax exempt, which could actually lead to higher prices for existing debt given scarcity.

Higher education and hospital sectors face potential impact to fundamentals

The potential for any changes to the tax exemption of municipal bonds is one source of concern for investors. Several other possible policy changes in the news could impact issuers of municipal bonds, particularly universities and hospitals.

As part of an escalating feud, the Trump administration is considering eliminating the tax-exempt status of select U.S. universities. The House reconciliation bill appears to contain language enhancing the authority of the administration to revoke non-profit status generally. The bill also seeks to increase the endowment tax from 1.4% to up to 21% for the largest endowments and proposes caps on student loans that may add pressure on admissions. These measures, along with targeted cuts to certain grant funding, could lead to balance sheet erosion for a number of universities.

The Trump administration is also proposing funding cuts that could impact both universities and hospitals. In addition to reducing funding that helps support some U.S. universities, potential cuts to Medicaid are being actively debated. Medicaid payments make up 19% of the revenue for hospitals across the United States; both states and the federal government jointly fund this program. The budget resolution passed in the House in February suggests potential funding cuts that could lead to a 1.5% to 2.0% revenue hit for affected hospitals.

States have a few options to make up for potential cuts to Medicaid. They can raise taxes and bridge the funding gap at the state level, but we think it is highly unlikely that states would absorb the full cost of the cuts. In fact, several governors, including ones from Illinois, New Jersey and California, have released statements. Instead, states could pass on the additional costs directly to the hospitals, meaning non-profit hospitals with outsized Medicaid exposures could be at risk.

As a result, we are focusing on major hospital systems that can withstand funding cuts and are actively screening for Medicaid exposure. We also note the proactive measures taken by management teams in both health care and higher education sectors that demonstrate a commitment to navigating these challenges effectively.

Overall municipal fundamentals remain resilient

Despite these risks, the municipal market's ability to adapt and respond to changing conditions remains a testament to its resilience. Municipal credit fundamentals are currently on solid ground, bolstered by strong economic growth and conservative budgeting practices at the state and local levels. Federal support during the pandemic has resulted in near-record levels of state and local reserves without significant increases in borrowing. For instance, the state of New York’s revenues have risen 96% over the past decade, while its nominal debt has increased by only 5%—a significant de-leveraging. Rainy day funds for states have increased substantially since the pandemic as states have built up large buffers should the economy change (Exhibit 2). This prudent fiscal management has improved leverage metrics, contrasting sharply with the federal government's large budget deficit.

Valuations and high absolute yields create an attractive entry point

Municipals have underperformed Treasuries over the last year and a half and now offer relatively attractive yields and ratios. Currently, municipal-to-Treasury ratios (a measure commonly used to assess the attractiveness of municipals relative to taxable fixed income) are either at or near their one-year highs across the curve. For example, the Bloomberg U.S. Municipal Bond Index offers a taxable equivalent yield over 6.5%, making munis more appealing than corporates on an after-tax basis, even for clients in the 24% tax bracket. Absolute yields are currently 1.13% above their 20-year average.

Technical backdrop is improving

Yield ratios have widened in recent weeks for several reasons. First, municipal yields have risen along with the broader fixed income market due to the uncertainty surrounding tariffs; volatility has also led to outflows. In addition, March and April are historically weak as supply outpaces demand because many people sell some of their muni holdings to pay their tax bills. These factors have led to municipal yields increasing by roughly 40 bps in April alone.

While March and April exhibited the usual seasonal weakness, the overall technical landscape of the municipal market is characterized by a robust supply story, driven by aging infrastructure and increased issuance. Record issuance in 2024 of around $500 billion included tax-exempt issuance that was 40% higher than the five-year average. This trend is expected to continue as municipalities address America's infrastructure challenges. The need for infrastructure improvements, such as roads and bridges, is a bipartisan issue, which should ensure continued federal support.

The demand story is equally compelling, as flows into the asset class have met the level of issuance. The seasonal aspect of municipal bonds, particularly during tax season, further enhances the market's appeal as the technical picture flips in the summer months. As municipalities leverage federal funding to finance infrastructure projects, the market is poised for continued growth and opportunity.

Outlook on munis

Municipal bond fundamentals are strong, valuations are compelling and the technical backdrop should improve over the coming months.

We expect municipal bonds will stay in the news, but we believe that any changes will be less severe than the current headlines suggest. In our view, volatility and headlines have often created opportunities for active managers who understand how policy changes will impact the municipal market and can adjust portfolios accordingly.