The Federal Reserve’s recent interest rate cut forecast may not meet the high expectations of fixed income investors, but the tax-exempt municipal bond market still holds promise for the upcoming year. Over the course of 2024, the central bank reduced interest rates on three occasions. However, policymakers now foresee only two more cuts in the new year, a decrease from the four reductions they predicted back in September. “There’s a great deal of uncertainty about the future path of interest rates,” remarked Paul Malloy, Vanguard’s head of U.S. municipals. “In light of that, if you’re looking for an asset that offers solid income and stability, muni bonds are an excellent choice.”
This year has seen financial advisors increasingly turning to municipal bonds to incorporate duration—exposure to bonds with longer maturities and higher price sensitivity—into their portfolios, hoping to capitalize on price increases as interest rates decline. Remember, bond prices and yields generally move in opposite directions. Moreover, in a diversified portfolio, municipal bonds serve to counterbalance stock market volatility. These bonds are particularly appealing to high-income investors living in states with high taxes, such as New York or California, thanks to their interest income, which is exempt from federal taxes. Additionally, if investors reside in the issuing state, they often dodge state and local taxes.
Rate policy isn’t the only item on investors’ radar as we head into the new year. With the Trump administration taking office in January, tax policy is gaining renewed attention. A number of provisions within the Tax Cuts and Jobs Act are set to expire by the close of 2025. Eric Golden, founder and CEO of Canopy Capital Group, points out, “2025 offers plenty of opportunities, but it also brings a lot of volatility given the impending changes.”
The Tax Cuts and Jobs Act, which was implemented in early 2018, roughly doubled the standard deduction, reshuffled individual income tax brackets, trimmed most tax rates, and capped the state and local tax deduction (SALT) at $10,000. With Republicans having control over both chambers of Congress and the White House, lawmakers might extend these expiring provisions, a development that could play out in the latter half of 2025, as noted by Bank of America municipal research strategist Yingchen Li in a recent report. Completely removing the SALT deduction cap might prove too costly, but lawmakers could consider raising the limit to, say, $20,000 for joint filers, as Li suggests. Such a change might reduce the demand for tax-exempt municipal bonds, the strategist cautions.
While the future of this legislation is still uncertain, the outlook for state and local governments looks bright. Vanguard’s Malloy highlights a “municipal bond trifecta for 2025,” consisting of attractive yields, robust municipal fundamentals, and strong rainy-day funds for state and local governments. A healthy economy and rising wages are also contributing to a positive forecast. “Credit remains quite appealing in the municipal sector, with fundamentals looking strong,” he added.
For those keen on the municipal bond space, investors able to handle some price volatility could find rewards by choosing issues with longer maturities. “I favor the longer end of the municipal yield curve because, unlike the Treasury curve, the muni curve has some slope and is steeper,” commented Malloy. As a matter of fact, the most successful segment of the muni curve is the 20-year mark, showing a total return of approximately 5.3%, according to a late November report from JPMorgan. “We predict an average return of 5.2% for bonds maturing in 15-25 years,” wrote Peter DeGroot, leader of JPMorgan’s municipal research and strategy team. “Our analysis indicates the weakest returns will be in the 1-5 year range at around 3.3%.”
For those wary of sharp price fluctuations, shorter-duration bonds present a viable alternative. These bonds offer steady income without as much sensitivity to interest rate changes. “The broader monetary policy narrative is now a pause in rate cuts,” mentioned Malloy, who noted that the shorter end of the market provides plenty of yield cushion for investors. Vanguard has recently launched its Short Duration Tax-Exempt Bond ETF (VSDM), an actively managed fund boasting an average duration of 2.7 years and a minimal expense ratio of 0.12%. The firm also offers a passively managed alternative: the Short-Term Tax-Exempt Bond ETF (VTES), with an average duration of 2.4 years and an expense ratio of 0.07%.
On the credit quality horizon, those prepared to take on a bit more risk could see increased yields. A total return analysis by JPMorgan found that BBB-rated muni bonds outperformed their AAA counterparts by about 1.8% on average across the curve. “Triple-Bs might be underestimated,” Golden remarked. “There’s a ripe environment for spread and yield compression as yields have climbed to a certain level, and spreads are becoming less attractive for double-A versus triple-B.” However, seeking deals, especially in the BBB category, might be better suited for professional fund managers rather than individual investors. “Making broad sector calls has become increasingly challenging,” noted Malloy. “We generally like credit, especially triple-Bs, but it’s important to be selective.”
