INSIGHTS

On September 29, 2025

AAM Viewpoints — Catalysts Piling Up for Municipals as the Fed Begins Cutting Rates

Both fundamentals and technicals play a key role in reaching conviction on a trade in financial markets and this holds true for the municipal (“muni”) market as well. On the fundamental side, the fiscal health of municipalities appears to be on solid ground. Moody’s recently reported state pension liabilities continue to decline. This, for years, has been somewhat of an “Achilles heel” for states, especially states with lower credit ratings. Money owed to pensions usually makes up the largest balance sheet liability. Throughout the last fiscal year, the municipal space saw adjusted net pension liabilities decline. Other liabilities, such as total net tax-supported debt, fell as well. Per Moody’s, “fiscal 2024 long-term liabilities totaled $2.2 trillion, down from $2.4 trillion in fiscal 2023.” Contributions by states to address these outstanding liabilities were strong; with over 60% of states contributing, that number was closer to 50% in 2021. It appears states have taken a more proactive approach in addressing outstanding pension costs. Lower rates over the next few years will also help refinancing costs. One would be remiss not mentioning some of the states with the highest liability total, which includes net tax-supported debt, adjusted net pension liabilities, adjusted net OPEB (other post-employment benefits) liabilities and other liabilities:

Source: Moody’s Research

The Fed embarking on a rate-cutting cycle could be another catalyst for municipals. Over the last three easing cycles, returns have been strong once looser financial conditions began to take hold. The Bloomberg Municipal 1-10-year Blend, after the 2007 cutting cycle began, was up 5.50% on an annualized basis over the next five years even including the Great Financial Crisis. Since 2015, negative years, for the most part, occurred during periods that saw the Fed hike rates like in 2016 and 2018. After the Fed started cutting in August of 2019, the index was up 3.20% over the next year. Since the Fed’s first rate cut last fall, Munis are up 2% in another strong showing.

On the technical side, another catalyst for municipals might be the steepened yield curve. One that is steeper than taxable counterparts and offering more attractive yield for taking on the same duration. Compared to both Treasury and corporate yield curves, the municipal curve is currently offering a better bang for your buck if you are looking to allocate to intermediate and long-term bonds. When comparing slopes, 10-year minus 2-year (10’s minus 2’s) Treasuries sits at 53 bps (basis points) while with the AAA muni yield curve has an 81bps spread. The 30’s minus 5’s spread sits at 105 bps with Treasuries, 130bps with corporates, and 207bps with munis. To start the year, municipal 30’s minus 5’s was at 94bps, with year-to-date steepening of over 100bps leading to opportunities for extending duration. We think it is hard to argue that for a fixed income investor putting money to work longer than 10 years that municipals aren’t the place to be when factoring in taxable equivalent yields as shown in the following chart from Creditsights:

Source: Creditsights | Past performance is not indicative of future results.

With the recent rally, tax-exempt investors have more to be happy about, with the broad market up 2.90% year-to-date as of last week. Fund flows have been strong and there seems to be a renewed optimism toward the asset class. Perhaps, partially because the “One Big Beautiful Bill” did not remove municipals’ tax-exempt status and attractive muni-to-Treasury ratios began catching the eye of savvy investors. New issuance has picked up as of late and seasonality may lead to some relief on spreads. Yields are lower compared to a few months ago, but the buying opportunity remains. Compared to other areas of the fixed income markets, municipals offer currently attractive spreads, especially in single A and BBB bonds, for an asset with a default rate of less than 1% going back to 1980. We believe valuations are still attractive and close to long-term averages, in addition to the other catalysts already mentioned, there could still be plenty of room to run for the asset class.

CRN: 2025-0902-12816 R