Navigating the Crossroads: Long Maturity Municipals in Q1 2025 Amid Tax Uncertainty and Yield Volatility

The first quarter of 2025 presented a paradox for long maturity municipal bonds: yields climbed to near 2023 highs, offering compelling value, while structural risks—from tax policy changes to healthcare sector vulnerabilities—clouded the outlook. Franklin’s Long Maturity Municipal SMA commentary underscores a market at a crossroads, where investors must balance attractive yields with heightened uncertainty.

Market Performance: Yield Volatility and the Steepening Curve

Long-dated municipal bonds struggled as yields surged, with 30-year maturities underperforming as rates rose nearly 50 basis points (bps) during Q1. This underperformance was amplified by a steepening yield curve, where two-year tax-exempt yields fell 10 bps, while 10-year yields rose 15 bps, widening spreads and penalizing long-dated exposures. .

The municipal-to-Treasury yield ratio also widened by 5–10 percentage points, a divergence last seen in fall 2023. This shift reflected investor fears that tax-exempt status—a cornerstone of municipal bond demand—could be altered to offset costs tied to extending the Tax Cuts and Jobs Act (TCJA).

Political and Policy Risks: Tax-Exempt Status Under Siege

The specter of tax reform loomed large. Proposals to cap tax benefits at 28% or restrict private activity bonds threaten the structural appeal of municipals. Historical precedents, such as the 2009 Build America Bonds program, suggest taxable alternatives may fail to displace tax-exempt demand. However, Franklin’s analysis warns that some form of reform is inevitable, with past administrations since Nixon consistently targeting municipal markets.

Meanwhile, the new administration’s budget blueprint introduced sector-specific risks:
- Healthcare: Proposed $880 billion in Medicaid cuts over a decade could destabilize hospital revenues, prompting cautious positioning in this sector.
- Higher Education: Reduced research funding and endowment taxes threaten issuers, though portfolio exposure remains limited.

Supply Dynamics and Investor Sentiment

New issuance hit $120 billion in Q1, a 20% increase over 2024, as issuers rushed to capitalize on current conditions and preempt legislative changes. Initial investor sentiment was positive, with weekly inflows averaging $1 billion, but late-quarter weakness raised concerns about demand sustainability.

Strategic Opportunities in Structured Credits

Amid the turbulence, Franklin identified pockets of value in non-traditional credits:
1. Prepaid Energy Bonds: Positions like Athene-backed securities offered spreads of +150 bps, far exceeding taxable corporate bonds from the same issuer.
2. Freddie Mac-Guaranteed Housing: Multi-family bonds provided 80–140 bps spreads, tracking Treasury performance while offering tax-exempt income.
3. Airport Bonds: Los Angeles International Airport (LAX) positions, representing ~15% of portfolios, benefited from monopoly-like advantages and diverse carrier bases.

These sectors offered “priced-to-perfection” valuations, but managers cautioned that generic long-term municipals faced compressed spreads, requiring selective credit picking.

Risks and the Road Ahead

The Fed’s path remains critical. Markets now price in 100 bps of easing by end-2026, up from earlier expectations, which could ease long-term yield pressures. However, geopolitical risks—including trade wars and unresolved inflation—add volatility.

The healthcare sector’s fragility and potential Medicaid cuts highlight the need for sector-specific caution. Meanwhile, the municipal market’s survival through prior reforms (e.g., TCJA, Reagan-era changes) suggests resilience, but structural adjustments are likely.

Conclusion: A Fragile Balance of Value and Risk

Long maturity municipals in Q1 2025 faced a dual narrative: yields near 2023 peaks offered a compelling entry point, but political and sector risks demanded discipline. Franklin’s strategy—prioritizing structured credits like prepaid energy and Freddie Mac-backed housing—highlighted how investors can capture spreads of +80 bps to +150 bps while mitigating exposure to Medicaid-dependent issuers.

However, the market’s “priced to perfection” state means even modest setbacks—such as a delayed Fed easing or tax reform breakthrough—could trigger volatility. With $120 billion in new issuance and late-quarter demand softness, the Q2 outlook hinges on whether investors will continue absorbing supply amid elevated risks.

For now, the verdict is clear: long maturity municipals demand a selective, risk-aware approach, leveraging non-traditional structures and high-quality infrastructure credits to navigate a landscape where yields are high, but the path to returns is littered with political and economic landmines.