The Strategic Case for Tax-Exempt Municipal Bonds in a Rising Rate Environment

In a financial landscape marked by persistent inflation and rising interest rates, investors are increasingly seeking assets that balance income preservation with tax efficiency. Tax-exempt municipal bonds have emerged as a compelling solution, particularly for those in higher tax brackets. This article examines the strategic advantages of municipal bonds in a rising rate environment, drawing on recent market trends and historical performance to build a case for their inclusion in diversified portfolios.

Income Preservation Through Competitive Yields

Municipal bonds have historically offered attractive yields, especially in long-term maturities. As of mid-2025, the yield-to-worst (YTW) of the Bloomberg Municipal Bond Index reached 3.96%, a level exceeded only 4.9% of the time historically [1]. This is particularly significant in a rising rate environment, where the tax-adjusted yields of high-quality municipal bonds (AA/A-rated) have ranged between 5% and 8%, outperforming corporate bonds by 100–200 basis points [5]. For example, a AAA-rated New York State bond priced at 5.10% offered an after-tax equivalent yield of 8.5% for taxable investors and 11.5% for New York City residents [4]. Such yields make municipal bonds a rare opportunity for income-focused investors, especially as Treasury and corporate yields struggle to keep pace.

The municipal yield curve has also steepened dramatically, with the 2-to-30-year slope at 162 basis points—more than double the 86 basis points in the Treasury market [5]. This steepness creates a unique value proposition for investors willing to extend duration, as long-dated municipal bonds (15–20 years) offer a balance between yield and risk, avoiding the volatility of the longest maturities while capturing much of the curve’s steepness [1].

Tax Efficiency as a Core Advantage

The tax-exempt status of municipal bonds is a critical differentiator, particularly for high-income taxpayers. In 2025, municipal yields exceeding 7% on a tax-equivalent basis have occurred only 11 times since 2007 [4]. When this threshold is breached, historical data shows strong forward returns: 12-month and 24-month average returns of 5.5% and 12%, respectively [4]. For instance, a taxpayer in the 37% federal tax bracket would see a 5.10% municipal bond yield equate to a 8.1% taxable yield, making it a superior alternative to corporate or Treasury bonds [4].

This tax efficiency is further amplified in states with high income tax rates. A New York City resident, for example, could achieve an after-tax equivalent yield of 11.5% on the same 5.10% municipal bond, effectively doubling the return compared to taxable alternatives [4]. Such advantages are not merely theoretical; in 2024, the Bloomberg Municipal Bond Index returned 1.05%, outperforming the Treasury index (0.58%) and corporate index (2.13%) [3]. Lower-grade municipal bonds (A, BBB, and high-yield) also outperformed, with returns of 1.78%, 2.87%, and 6.32%, respectively, as credit spreads tightened [3].

Historical Resilience in Rising Rate Environments

Municipal bonds have demonstrated resilience during past periods of rising rates. From 1980 to 1990, the Bloomberg Municipal 22+ Long Index returned 6.57% annually, outperforming the Treasury index’s 6.30% [2]. Similarly, in 2024, municipal bonds outperformed equities and Treasuries amid high inflation, supported by strong state and local tax collections (up 6.4% year-over-year) and a net positive rating outlook [3].

However, the 2025 market has faced challenges, including a record surge in new issuance ($256 billion in the first half of 2025) and downward pressure on long-end bond prices [1]. Despite this, historical patterns suggest that steep municipal curves often precede strong forward returns for long-dated bonds, particularly high-quality issues [4]. For example, the 214 basis point spread observed in 2025 could signal future gains as the market corrects.

Strategic Considerations for Investors

While the tax-exempt status of municipal bonds remains under political scrutiny, proposals to eliminate or limit exemptions (e.g., targeting private activity bonds) are unlikely to erase their appeal. Removing the tax exemption could increase state and local borrowing costs by 35%–40%, harming infrastructure financing and economic growth [5]. Given these risks, it is more probable that any changes will target specific subsets of the market rather than the broader tax-exempt framework.

For investors, locking in long-dated municipal yields now could prove advantageous. With the Federal Reserve anticipated to cut rates later in 2025, the current environment offers a rare opportunity to capture both income and capital appreciation. Intermediate-term municipal bond funds also provide flexibility, allowing managers to employ strategies like roll-down gains and coupon income to mitigate rate risks [1].

Conclusion

Tax-exempt municipal bonds present a strategic case for income preservation and tax efficiency in a rising rate environment. Their competitive yields, tax advantages, and historical resilience make them a compelling addition to portfolios, particularly for high-income investors. While challenges like supply-driven volatility exist, the long-term outlook remains favorable, especially as the market adjusts to potential Fed rate cuts and policy stability. For those seeking to balance income with tax optimization, municipal bonds offer a rare and historically proven opportunity.

Source:
[1] Top 5 Muni Market Insights 2025: Mid-Year Update [https://www.newyorklifeinvestments.com/insights/2025-municipal-market-insights-midyear]
[2] Municipal bonds today offer U.S. taxpayers a rare, compelling opportunity [https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/ideas-and-insights/municipal-bonds-today-offer-us-taxpayers-a-rare-compelling-opportunity]
[3] Weekly Municipal Monitor—Year in Review [https://www.westernasset.com/us/en/research/blog/weekly-municipal-monitor-year-in-review-2025-01-07.cfm]
[4] A Historic Dislocation: Opportunity at the Long End of the Municipal Curve [https://www.morganstanley.com/im/en-us/individual-investor/insights/articles/opportunity-at-the-long-end-of-the-municipal-curve.html]
[5] Is Eliminating the Tax Exemption on Municipal Bonds Worth the Cost [https://www.parametricportfolio.com/blog/is-eliminating-the-tax-exemption-on-municipal-bonds-worth-the-cost]