Strategic Allocation to Non-Rated Municipal Bonds: Enhancing Tax-Advantaged Income in a High-Yield Environment

In the current investment landscape, tax-advantaged income generation has become a critical strategy for investors navigating a volatile market. Municipal bonds, particularly non-rated issues, offer a compelling avenue to achieve this goal while balancing yield enhancement and credit risk management. As of June 2025, the Bloomberg Municipal Bond Index yielded 4%, reflecting elevated returns that outpace both taxable debt and equities [1]. This environment, coupled with a steepened yield curve and strong credit fundamentals, positions non-rated municipal bonds as a strategic asset class for income-focused portfolios.

The Case for Non-Rated Municipal Bonds

Non-rated municipal bonds, often overlooked in favor of their rated counterparts, provide access to higher yields without necessarily compromising credit quality. While 72% of the municipal bond market remains in the top two credit ratings (AAA/Aaa or AA/Aa), non-rated bonds can offer attractive spreads, particularly in sectors with strong fiscal health but limited access to traditional rating agencies [2]. For instance, smaller municipalities or specialized projects (e.g., infrastructure or education) may issue non-rated bonds to fund initiatives that align with long-term tax-exempt income goals.

The key to unlocking value in this space lies in active management. A bottom-up research-driven approach—such as that employed by Invesco—enables investors to identify mispriced credits and capitalize on dislocations in the secondary market. This strategy is especially relevant in 2025, where a surge in municipal bond issuance has created opportunities for selective investors to access undervalued securities [1]. By focusing on granular credit analysis, investors can mitigate the risks associated with non-rated bonds while capturing enhanced yields.

Credit Risk Management in a High-Yield Context

Despite the allure of higher returns, credit risk remains a central concern. However, the municipal bond market has demonstrated resilience, with 17 consecutive quarters of more upgrades than downgrades by Moody’s Investors Service [1]. This trend underscores the robustness of state and local fiscal positions, supported by significant reserve balances. For example, 34 states are projected to maintain reserves sufficient to withstand a 10% revenue decline in 2026 [2]. These buffers, combined with the flexibility to adjust expenditures, provide a safety net against macroeconomic headwinds such as Medicaid cost shifts or economic slowdowns.

Non-rated bonds, while inherently less scrutinized, are not immune to these credit fundamentals. Active managers can leverage bottom-up research to assess the financial health of individual issuers, ensuring that yield enhancement does not come at the expense of excessive risk. This approach aligns with the broader market’s emphasis on relative value, where investors seek to exploit inefficiencies in pricing rather than relying solely on rating agency assessments.

Tax-Exempt Income: A Unique Competitive Advantage

The tax-exempt nature of municipal bond income remains a cornerstone of their appeal, particularly for investors in higher tax brackets. With the muni tax exemption preserved by recent legislative developments, the effective yield on these securities is amplified [1]. For example, a 4% yield on a municipal bond could equate to a 6.15% taxable-equivalent yield for an investor in the 35% tax bracket. This advantage is further enhanced by the steepening muni yield curve, which rewards investors who extend duration in pursuit of higher returns [2].

Moreover, the market’s response to policy uncertainties—such as potential SALT deduction caps—has spurred increased retail demand for municipal bonds, particularly in high-tax states like New York and California [1]. This demand-driven dynamic supports valuations and reinforces the case for strategic allocation to non-rated issues, where liquidity premiums can be captured without sacrificing credit quality.

Conclusion

In a market characterized by macroeconomic uncertainty and equity volatility, non-rated municipal bonds offer a unique combination of tax-advantaged income, elevated yields, and manageable credit risk. By adopting a bottom-up, research-driven approach—akin to Invesco’s methodology—investors can navigate the complexities of this asset class and capitalize on dislocations in the secondary market. As issuance levels moderate in the second half of 2025, the stage is set for a recovery in total returns, making strategic allocation to non-rated munis a compelling strategy for income-focused portfolios.

Source:
[1] Municipal Bonds: Mid-Year 2025 Outlook, https://www.schwab.com/learn/story/municipal-bond-outlook
[2] Top 5 Muni Market Insights 2025: Mid-Year Update, https://www.newyorklifeinvestments.com/insights/2025-municipal-market-insights-midyear