Tactical Municipal Bond Strategies in a Rising Rate Environment: Navigating 2025's Market Dynamics

In 2025, municipal bond investors face a complex landscape shaped by rising interest rates, fiscal uncertainties, and evolving tax policies. Historical performance during recent rate hikes underscores the need for tactical positioning, while expert strategies highlight opportunities in duration extension, credit selection, and active management. This analysis synthesizes market data and expert insights to outline a roadmap for navigating these challenges.

Market Context: Underperformance and Volatility

The municipal bond market has struggled during the 2020–2025 rising rate cycle. In Q2 2025, the Bloomberg Municipal Bond Index recorded a -0.12% return, lagging behind the U.S. Fixed Income Aggregate Index's 1.21% gain, according to AMP's Q2 2025 review. Short-maturity munis (10 years or less) outperformed, while long-term bonds faced pressure. Industrial revenue bonds bucked the trend with a 0.55% return, whereas the hospital sector faltered due to valuation concerns and potential Medicaid cuts, the review notes.

Municipal/Treasury yield ratios surged to 88% for 10-year and 102% for 30-year maturities, levels over four standard deviations above the two-year average, the AMP review found. This dislocation attracted "crossover" buyers-taxable investors seeking relative value-but long-term munis remained undervalued compared to Treasuries by quarter-end, per the same review. Meanwhile, the yield curve steepened: 5-year AAA municipal yields fell 15 basis points, while 30-year yields rose 26 basis points; analysts attribute this to tepid mutual fund demand and broader fiscal risks, according to the AMP analysis.

Tactical Strategies: Duration Extension and Barbell Structures

Amid these dynamics, experts advocate duration extension as a core strategy. By locking in higher yields on long-term munis, investors position for potential rate declines and tax-equivalent yield advantages. For example, high-tax states like California and New York offer long-term municipal bonds with yields rivaling equities but with lower volatility, as a Fortune article observes. AllianceBernstein's outlook notes that extending duration aligns with expectations of continued Fed rate cuts in 2025.

Complementing this is the barbell maturity structure, which combines short- and long-term bonds to balance yield capture and interest rate risk. Short-term munis (1–3 years) provide liquidity and stability, while long-term bonds (10+ years) capitalize on steep yield curves. Intermediate maturities are selectively included to smooth cash flows, the AllianceBernstein outlook adds. This approach leverages "rolldown" effects-where bonds move along the yield curve as they approach maturity-while maintaining flexibility to adjust as market conditions evolve, according to MunicipalBonds' analysis.

Credit Opportunities: Non-Investment Grade Bonds

Credit strategies also gain prominence. Non-investment grade munis (e.g., BBB- and A-rated bonds) offer significantly higher yields than investment-grade counterparts, with spreads favoring income-focused investors, AllianceBernstein finds. Despite tighter spreads, these bonds remain attractive due to strong municipal fundamentals and low default rates. For instance, industrial revenue bonds outperformed in Q2 2025, suggesting sector-specific opportunities. However, due diligence is critical to avoid sectors like healthcare, which face valuation headwinds, the AMP review cautions.

Tax Policy Uncertainties and Active Management

The looming expiration of the 2017 Tax Cuts and Jobs Act (TCJA) introduces uncertainty, particularly regarding the SALT deduction cap, a risk highlighted in MunicipalBonds' mid-2025 analysis. This could shift demand for tax-exempt income, making active management of relative after-tax yields essential. Investors must compare municipal bonds to taxable alternatives like Treasuries and adjust allocations accordingly. Active duration management-shifting maturities based on yield curve movements-becomes a key tool in this environment, AllianceBernstein recommends.

Conclusion: Embracing Flexibility and Proactive Positioning

The 2025 municipal bond market demands a blend of strategic foresight and agility. Duration extension, barbell structures, and credit diversification offer pathways to capitalize on steep yield curves and attractive tax-equivalent yields. Meanwhile, active management ensures portfolios adapt to fiscal policy shifts and evolving rate expectations. As historical trends suggest, tactical strategies outperform passive approaches in such environments, AllianceBernstein concludes. For investors willing to navigate the complexities, municipal bonds remain a compelling vehicle for tax-efficient income.