An Uncommon Yield Environment for Municipal Bonds

For more than a decade, municipal bonds have been prized for tax-exempt income and stability, while their yields stayed modest by historical standards. As of Q3 2026, that narrative has fundamentally changed, and municipal bond tax equivalent yields (TEYs) have reached levels not seen by many of the current generation’s investors. The selloff in the third quarter lifted municipal yields to their highest levels in 15 years and followed a broad repricing in fixed income that pushed the 10-year Treasury yield above 5.3% for the first time since 2002. Yield-To-Worst on the Bloomberg Municipal Index reached 4.86%, its highest level since December 2008, after rising about 120 basis points in the third quarter alone. The market’s taxable-equivalent yield now exceeds 8% for top-bracket investors, the highest in nearly 20 years. In our view, starting yields this high are uncommon, and long-term investors in the top tax bracket may find that they merit a fresh look.

Like most attractively priced investments, getting to this point was painful. The municipal market returned -6.35% in the third quarter, its worst quarter since 1981, and September’s -4.36% return was its worst month since 2008. It is important to understand why yields rose; the selloff was driven by rates and technical factors, not by deteriorating credit. A hawkish Federal Reserve raised its policy rate in September for the first time since 2023 and signaled more tightening to come. At the same time, an energy-driven inflation scare pushed yields higher across the fixed income market. Municipal issuance was also at a record pace, with roughly $504 billion through the third quarter and the busiest September on record. Dealers and investors had to absorb record supply at exactly the toughest moment. Several large issuers, including Los Angeles, Nashville, and New Jersey, postponed deals in late September rather than sell into the volatility.

In our view, the picture looks better when you consider that the drivers were rising rates and technicals rather than credit. Investors are being paid more today for credit quality that we believe is broadly unchanged. Ten-year muni-to-Treasury ratios rose to about 77% and 30-year ratios to about 91%. State and local governments entered this period with rainy day funds and reserve balances near historic highs, and most essential-service revenue bonds continue to generate healthy coverage. Defaults remain rare and are concentrated in narrow, high-risk niches rather than the core of the market. Municipal bonds are now cheaper relative to Treasuries than at any point this year. This, combined with the municipal market’s credit quality characteristics, may make valuations more attractive to investors seeking tax-exempt income.

Muni Defaults Remain Low Relative to Taxable Bonds

10-Year Default Rates by Credit Quality

History suggests that starting yield is a strong bellwether of a bond investor’s long-term return potential, and today’s levels provide meaningful cushion against further rate volatility. At a 5% tax-exempt yield, a bond can absorb a considerable further rise in rates before its total return turns negative over a one-year horizon. Seasonal patterns may also be relevant. Issuance has typically slowed late in the year, reinvestment demand from coupons and maturities has typically built, and October has historically had the lightest redemption calendar of the year. Exchange-traded funds attracted more than $2 billion of inflows in late September, suggesting that some investors are already moving to lock in these levels.

We believe a disciplined, research-driven approach may help investors identify opportunities in this environment. We continue to favor revenue bonds backed by essential services over general obligations, and see particular value in water and sewer, public power, and select charter schools. On the yield curve, the 3- to 15-year portion of the curve continues to offer an attractive balance of yield and rate sensitivity. Investors seeking more income may also find opportunities in longer maturities, which generally offer higher yields but are more sensitive to interest rate changes and carry greater risk. We remain selective in lower-rated credit, where spreads have not widened enough to compensate for sector-specific risks.

No one can call the exact peak in yields, and further volatility is possible while the Federal Reserve continues to fight inflation. While uncertainty remains, current market conditions may present opportunities for municipal bond investors. Tax-exempt yields at 15-year highs, taxable-equivalent yields near 20-year highs, and broadly stable credit quality may provide a favorable backdrop for long-term investors.