Why Taxable Local-Government Bonds Are Outperforming the Muni Market in 2025: Capitalizing on Supply-Driven Dislocations and Relative Value

The municipal bond market in 2025 has been a tale of two segments: tax-exempt bonds, which have struggled under supply-driven headwinds, and taxable local-government bonds, which have quietly outperformed despite—or perhaps because of—the chaos. While the broader muni market has been battered by record issuance and compressed spreads, taxable bonds have carved out a niche of relative value, offering investors a compelling mix of yield, credit quality, and strategic positioning in a structurally attractive corner of the fixed-income universe.

Supply-Driven Dislocations: The Catalyst for Outperformance

The first half of 2025 saw a record $271 billion in municipal bond issuance, with taxable bonds surging 26% year-over-year. This surge was fueled by inflation-driven infrastructure costs, a backlog of deferred maintenance, and the need to fund projects that don't qualify for tax-exempt treatment. Unlike tax-exempt bonds, which faced volatility tied to tax policy uncertainty, taxable bonds have benefited from a more stable demand profile.

The key to their outperformance lies in supply-driven dislocations. Tax-exempt issuance, which hit $256 billion through June 2025, overwhelmed the market, compressing spreads and driving down prices. Taxable bonds, however, have seen a more measured supply increase, allowing yields to remain attractive. For example, short-duration high-yield taxable munis currently yield 4.74%, translating to a taxable-equivalent yield of 8.01% for investors in the top federal tax bracket. This is a stark contrast to the 3.30% yield on 10-year AAA tax-exempt bonds, which offer only 5.69% taxable-equivalent value.

Relative Value: The Hidden Gem in a Buyers' Market

The municipal yield curve has steepened dramatically in 2025, with 20-year AAA municipal yields rising 24 basis points while 2-year yields fell 10 basis points. This steepening has created a unique opportunity for taxable bonds, particularly in the 5- to 10-year duration range, where yields are elevated relative to Treasuries. For instance, a 7-year taxable municipal bond yielding 4.10% offers a taxable-equivalent yield of 6.89% for top-bracket investors—competing directly with corporate bonds that have not seen similar yield increases.

Moreover, the municipal-to-Treasury (M/T) ratio for taxable bonds has reached historically attractive levels. At 94% pre-tax and 158% on a taxable-equivalent basis for 30-year AAA municipals, the relative value of taxable bonds is compelling, especially as the Federal Reserve signals potential rate cuts in the second half of 2025. These cuts could drive a rotation from cash into municipal bonds, with taxable bonds likely to benefit due to their higher yields and shorter durations.

Credit Quality and Sector Dynamics

Taxable local-government bonds have also outperformed due to their strong credit fundamentals. Unlike tax-exempt bonds, which are often backed by dedicated revenue streams (e.g., toll roads, airports), taxable bonds are typically general obligation (GO) bonds or revenue bonds for projects like water systems, schools, and public housing. These bonds are issued by municipalities with robust fiscal health, as evidenced by low debt ratios and strong reserve balances.

The healthcare and higher education sectors, which have seen significant taxable issuance, are particularly noteworthy. For example, a $3.8 billion inflow into high-yield municipal funds year-to-date has been driven by demand for taxable bonds in these sectors, which offer both income and diversification benefits. The inverted credit spread curve—where short-duration taxable bonds trade at wider spreads than long-duration counterparts—further enhances their appeal for rate-sensitive investors.

Strategic Implications for Investors

For investors seeking to capitalize on these dynamics, the playbook is clear:
1. Focus on Short- to Intermediate-Duration Taxable Bonds: These segments offer the best yield-to-risk ratios, especially as the Fed's rate cuts loom.
2. Target High-Quality Sectors: Prioritize bonds from municipalities with strong credit ratings and stable revenue streams, such as water and sewer systems or public housing projects.
3. Leverage Tax-Equivalent Yields: For investors in the 37% tax bracket, a 4.5% taxable bond yield translates to a 7.0% taxable-equivalent yield—outperforming many corporate bonds.
4. Avoid Overexposure to Tax-Exempt Bonds: While tax-exempt bonds remain attractive for high-bracket investors, their performance has been muted by supply-driven dislocations and compressed spreads.

Conclusion: A Structural Shift in the Muni Market

The 2025 municipal bond market has been defined by structural shifts: record issuance, tax policy uncertainty, and a steepening yield curve. While tax-exempt bonds have borne the brunt of these pressures, taxable local-government bonds have emerged as a resilient and underappreciated asset class. By capitalizing on supply-driven dislocations and the relative value of taxable yields, investors can position themselves to outperform in a market where traditional strategies are no longer sufficient.

As the year progresses, the combination of elevated issuance, favorable tax-equivalent yields, and the potential for Fed rate cuts will likely drive further outperformance in taxable munis. For those willing to look beyond the headlines, this segment offers a rare opportunity to combine income, diversification, and capital preservation in a high-interest-rate environment.