Municipal Bonds: A Hidden Gem in Taxable Markets—Why Active Managers Are Finding Gold in the Short End and High Yield

The municipal bond market is currently at a crossroads. Record issuance volumes, compressed valuation metrics, and a bifurcating credit landscape are creating a once-in-a-decade opportunity for active managers to generate outsized returns. While passive investors may struggle to navigate the uneven terrain, those with the agility to parse credit quality, exploit supply-driven inefficiencies, and focus on the short end of the curve and high-yield sectors stand to benefit handsomely. Let's unpack the data and the strategy.

The Supply Surge: A Catalyst for Opportunity

Year-to-date through June 2025, U.S. municipal bond issuance has already hit $280 billion, with June alone setting a record at $57 billion. This represents a 15% year-over-year increase, driven by a 757% surge in alternative minimum tax (AMT) eligible bonds and a 19% rise in taxable issuance. While this heavy supply has pressured prices temporarily, it has also created a buyer's market for active managers.

The key metric here is the municipal-to-Treasury ratio, which measures how closely municipal bond yields track Treasury yields. As of June 2025, the 10-year AAA municipal yield sat at 78% of the Treasury yield, the highest ratio since late 2023. This compression reflects both the relative cheapness of munis and the demand for tax-advantaged income in a rising-rate environment.

Credit Differentiation: Where Active Management Shines

Not all municipal bonds are created equal. The market is splitting into two distinct segments:
1. Investment-grade issuers with strong credit metrics (e.g., states like Texas or California) and
2. High-yield credits (e.g., smaller cities, airports, or hospitals) with higher risk but compelling yields.

The bifurcation is stark. High-yield municipal bonds now offer yields of 5.59% (or 9.44% taxable-equivalent for top earners), outpacing corporate high yield by 167 basis points in spreads. Yet defaults remain low: only 0.1% in 2024, versus 4.7% for corporate high yield.

Active managers can capitalize here by:
- Favoring short maturities: The short end of the curve (5–10 years) offers embedded call features that limit duration risk. The 5-year AAA yield has steepened to +118 bps over Treasuries—the steepest since 2017.
- Targeting overlooked AMT bonds: The 757% issuance surge has created discounts in AMT-eligible bonds, which often offer 100+ bps premium over broad-market indices.
- Avoiding overexposure to policy risks: Municipalities relying on expiring federal aid (e.g., ARPA funds) or vulnerable sectors (e.g., airports) require careful scrutiny.

Why Reallocate Now? The Case for Immediate Action

The data is unequivocal: munis are undervalued relative to taxable assets, and the window to act is narrowing.

1. Tax-equivalent yields are irresistible: For a top-bracket taxpayer, a 5% municipal yield translates to 8.3% taxable-equivalent—a steal in a low-yield world.
2. Supply is peaking, demand is rising: Q1 2025 saw $9.7 billion flow into muni funds, with $4.8 billion targeting high yield. Summer seasonality will likely slow issuance, easing technical pressures.
3. Fed support is in play: While the Fed's rate cuts remain uncertain, the muni market's negative correlation with Treasuries (due to tax-exempt status) provides a hedge against volatility.

The Active Manager's Playbook

To thrive, investors must avoid passive indexing and embrace a research-driven strategy:
- Prioritize quality: Focus on issuers with 100+ days of liquidity reserves (e.g., Texas, North Carolina) and avoid those with ARPA dependency (e.g., 33% of cities face budget shortfalls post-2025).
- Ladder maturities: Use short-dated bonds (3–5 years) to lock in yields while avoiding long-duration risk.
- Exploit AMT inefficiencies: Pair AMT bonds with tax-loss harvesters or institutional buyers seeking their unique characteristics.

Final Word: Act Before the Tide Turns

The municipal bond market is a mosaic of opportunity today. Record issuance has created a seller's market that is ripe for active managers to pick through the rubble. With yields at multiyear highs relative to Treasuries, credit spreads offering equity-like returns, and the Fed's backstop in place, now is the time to reallocate to munis—but do so selectively. The passive crowd may miss the nuances, but the data demands that investors act now before this rare valuation window closes.

The municipal bond market isn't just a safe haven—it's a gold mine for those willing to dig deeper.