Tax-Exempt Municipal Bonds in a High-Yield Environment: Strategic Value and Portfolio Implications

In 2025, tax-exempt municipal bonds have emerged as a compelling asset class for investors seeking both income and diversification in a high-yield environment. With municipal bond yields diverging sharply from Treasuries and corporate bonds, the Bloomberg Municipal Bond Index’s average yield-to-worst of 3.98% in July 2025 translates to a taxable-equivalent yield (TEY) of 6.72% for top taxpayers [2]. This makes municipals particularly attractive for high-net-worth individuals, who can leverage their tax-exempt status to outperform taxable alternatives. For instance, the S&P National AMT-Free Municipal Bond Index’s TEY surged to 6.36% by April 2025, up from 5.69% earlier in the year [3], underscoring the growing appeal of these securities.

The municipal yield curve has steepened dramatically, with the 30-year/5-year AAA municipal spread widening to 217 bps by July 2025 [1]. This steepness, historically observed only during periods of market stress (e.g., the 2007–2008 Global Financial Crisis and the 2013 Taper Tantrum), has created opportunities for investors to capitalize on the “roll-down” strategy. By purchasing long-end municipals and selling before maturity, investors can capture both yield and capital appreciation, as historical data shows such periods often precede strong 12-month returns for long-dated bonds [1].

Credit quality remains a cornerstone of municipal bonds’ appeal. Over 72% of municipal bonds are rated AAA/Aaa or AA/Aa, reflecting robust financial health among issuers [4]. While high-yield municipals carry slightly more risk, their default rates remain significantly lower than those of high-yield corporate bonds. For example, between 1970 and 2023, high-yield corporate bonds defaulted at a rate four times higher than their municipal counterparts [5]. This resilience, combined with the tax advantages of municipals, positions them as a safer, more tax-efficient alternative to corporate bonds, especially for investors in higher tax brackets.

From a diversification perspective, municipal bonds offer a unique balance of yield, credit quality, and tax efficiency. The Bloomberg Municipal Bond Index’s 3.96% yield as of June 2025 [6] outpaces many global sovereign bonds, including U.S. Treasuries, which have lost their final AAA rating [7]. Moreover, the surge in municipal bond issuance—$256 billion in the first half of 2025—has created a favorable supply-demand dynamic, with high-yield municipals offering a taxable-equivalent yield of 9.81% [5]. This makes them an ideal complement to equities and corporate bonds in a diversified portfolio, particularly as active management strategies focus on credit selection and relative value analysis [6].

However, the long-end of the municipal market has faced volatility, with the 22+ year segment declining -4.86% year to date [1]. While this dislocation raises concerns, it also presents entry points for tax-sensitive and institutional investors. The key lies in balancing exposure to long-end municipals with shorter-duration issues to mitigate interest rate risk while capturing the steep yield curve’s potential.

In conclusion, tax-exempt municipal bonds are a strategic asset in today’s high-yield environment. Their combination of tax advantages, credit resilience, and diversification benefits makes them a cornerstone for portfolios seeking income and stability. As the municipal market navigates supply pressures and yield curve dynamics, disciplined investors stand to benefit from both current yields and future capital appreciation.

Source:
[1] Weekly Municipal Monitor—Yield Curve Steepening, [https://www.westernasset.com/us/en/research/blog/weekly-municipal-monitor-yield-curve-steepening-2025-08-05.cfm]
[2] Muni Monthly—July 2025 | Western Asset, [https://www.westernasset.com/us/en/research/blog/muni-monthly-july-2025-2025-08-18.cfm]
[3] Municipal Bond Market Mid-Year 2025 Review, [https://www.spglobal.com/spdji/en/commentary/article/municipal-bond-market-mid-year-2025-review-seeking-yield-and-stability-amid-market-volatility/]
[4] Municipal Bonds: Mid-Year 2025 Outlook, [https://www.schwab.com/learn/story/municipal-bond-outlook]
[5] Harnessing the high yield municipal bond advantage | Insights, [https://etf.macquarie.com/us/en/resources/insights/harnessing-the-high-yield-municipal-bond-advantage.html]
[6] Top 5 Muni Market Insights 2025: Mid-Year Update, [https://www.newyorklifeinvestments.com/insights/2025-municipal-market-insights-midyear]
[7] The case for US municipal bonds Versus Treasuries, [https://www.insightinvestment.com/uk/perspectives/the-case-for-us-municipal--bonds-versus-treasuries/]