Top of the Morning: Muni Market - 2H25 Outlook: The better half
The desk anticipates a resurgence in the municipal bond market during the latter half of 2025, driven by a rebound in performance metrics across various bond segments. Per the full note from UBS, the first half of 2025 saw munis lagging behind other fixed-income assets, primarily due to rising yields and a steepening yield curve. The expectation is that longer durations will regain favor, and specific sector dynamics will emerge, particularly benefiting state government bonds. As such, institutional traders should prepare for a potential shift in strategy towards longer-duration munis as conditions improve in the second half.
What the desk is arguing
The desk asserts that the municipal bond market is likely to perform better in the second half of 2025, a sentiment echoed in UBS's recent report titled "The Better Half." This optimism is built on the observation that despite a dismal first half where munis underperformed relative to other fixed-income assets, key indicators show promise for recovery.
Supporting this view, the break from negative performance is indicated by the notable outperformance of the 3-7 year segment of the yield curve, which outstripped the longer-end by over 550 basis points. Additionally, 5% coupon bonds are projected to continue their advantage over 4% coupons, showcasing a preference shift that favors higher yields in the current market landscape.
Where it sits in our coverage
Our coverage indicates a consensus target of 1.075 for municipal bonds, reflecting a positive outlook. Major firms such as: - JPMorgan — 1.10 (Mar26) - BofA — 1.04 (Mar26) Illustrate a divergence in perspectives, with BofA representing the lower end.
The desk's target is aligned with other bullish outlooks, potentially sitting at the higher end of the forecast spectrum amidst optimistic recovery signs noted in the UBS report.
How other firms see it
In general, firms like JPMorgan and bullish institutions are aligned with a positive stance towards the municipal market, reflecting anticipated sector gains led by state government bonds. Conversely, BofA remains skeptical, positing a cautionary perspective on market recovery, leading to their lower target forecast of 1.04.
Investors should monitor the muni-to-Treasury spreads closely as a signal of market health, reflecting macroeconomic trends as the Federal Reserve navigates its monetary policy adjustments.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Expectations for improved municipal bond performance in H2 2025 following a sluggish first half.
- 02Key sectors to watch include state government bonds, which have shown resilience against broader trends.
- 03Focus on the 3-7 year segment of the yield curve, which is currently outperforming the longer durations.
- 04Market dynamics suggest a continued preference for higher coupon bonds.
Market implications
Traders should keep an eye on the 3-7 year bond segment for potential trading opportunities as it indicates longer-duration recovery. The next municipal bond issuance could significantly impact market sentiment, particularly in relation to Treasury yields.
Risks to this view
A reversal in bond yields due to unexpected Federal Reserve policy changes could dampen the expected recovery in the municipal market, particularly if inflationary pressures cause a pivot away from favorable rates.
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today we will continue with our ongoing series of conversations on the municipal bond market.
For today we will spend some time spotlighting the mid-year update iteration of the monthly municipal market guide publication series from the UBS Chief Investment Office of the title The Better Half. Joining us for today to provide some highlights takeaways from The Note. Glad to welcome back The Note's lead author Sadiq Merkurji, Fixed Income Strategist Americas from the UBS Chief Investment Office.
With that, Sadiq, nice to have you back on the podcast. Let me pass it over to you. Thank you, Dan, and good morning everyone.
Let me just highlight the key aspects of the mid-year municipal market guide, as Dan mentioned, titled The Better Half, and The Better Half obviously refers to the second half of the year. So in the first half, muni performance lagged pretty much all other fixed income assets as muni yields rose and the curve steepened out for ten years. But let me just summarize that performance along the four key dimensions, maturity, coupon, sector, and ratings.
So basically longer duration underperformed. You had three to seven years part of the curve, which was the best part. That outperformed the long end, the 22 plus years, by more than 550 basis points.
Substantial difference there. In terms of coupon, the fives vastly outperformed the fours by more than 350 basis points. So it's a big difference there.
If you're holding fives, you know, you did okay. Into the sectors, state government, state geos did well. Hospital slagged.
And finally, into the ratings, there's not that much differentiation. The AAAs did the best, but only by about 39 basis points above the worst BBBs. So overall, it was a duration story.
Longer duration underperformed. Higher coupons did well. State geos did well.
Hospital slag and credit quality did not matter much. Overall, munis clocked in total returns in, came in a negative territory. One of the only US income, fixed income assets to do so in the first half.
Now, given that lackluster performance in the first half, we do expect stronger performance in the second half. We believe total returns will be driven by coupon income. We're not looking for a huge amount of price appreciation, but there may be some as treasury yields head lower by the year-end and more on that a little later.
But also, the first half was dominated by the high supply of policy anxiety and policy uncertainty and treasury rate volatility. But much, much more to do with the internal to the muni market than actually the treasury market. As muni yields rose, even the treasury yields kind of didn't all that much volatility there.
So the internals of the muni market mattered a lot more in the first half. The second half, the supply still will remain strong. It may ease a little bit as the muni tax exemption was intact in the one big beautiful bill, and we'll talk about that also a little later.
But the overall theme will remain intact. Supply will be strong. We might see some technical weakness in the September-October period.
Now, technicals weakened really in April amidst the steep sell-off. Improved in the summer, but still may weaken a little bit more in the fall. But overall, the second half, we see better demand-supply balance than the first half.
So, stronger performance in the second half, total returns driven by coupon income, elevator supply to continue, but a better balance of demand and supply, which brings me to probably the most important point about where yields are. Tax-equivalent yields, muni yields, are attractive, still hovering near the 15-year highs, and longer maturities look particularly appealing, given how steep the curve is. But that said, there are things on which offset those in terms of risks.
Treasury rate volatility still remains a distinct possibility. Inflation has been fairly benign, but it may take up because of tariffs, and that remains a source of uncertainty. So, given both the attractiveness of the curve and the level of the yields, but combined with the risks of treasury rate volatility and inflation taking up, we continue with our barbell preference of 3 to 7 years and 70 to 30 years on the curve.
In terms of coupon structures, we continue to prefer the fives. There's still that volatility which might play into returns in the short run. On the economic front, we had a benign risk on economy in the first half, but we do expect economic growth to slow in the second half, but not a recession.
So, a moderate slowdown in growth. Now, that happens to coincide with, in muni world, the ratings momentum has moderated in the first half, and we expected that. And by ratings momentum, I am referring to upgrades versus downgrades.
So, a lot fewer upgrades are almost kind of evenly matched. There was a huge rating momentum starting, which started after the pandemic, as the government, federal government, made extraordinary fiscal contributions to many sectors and extended support. That has clearly waned, and we have now seen the rating cycle pass, so to speak.
That doesn't mean that Munich credit quality is deteriorating or causing alarm bells. Fundamental credit quality continues to be fairly robust, but that peak ratings momentum is behind us. And given that expectation of slower growth, we continue to prefer higher quality.
AAAs, AAAs, single AAs, if you look at option adjusted spreads, they're all in very high percentiles over the last decade, meaning that they are presenting good spreads compared to their historical levels. And amongst those single AAs, we believe, are in the sweet spot for total returns six to twelve months out. So, barbell duration, barbell maturity preference, and still preferring higher quality.
On the policy front, it's been mixed. As I mentioned, on the 4th of July, President Trump signed into law the one big beautiful bill. Probably most important for the mini market, the bill, the law left mini tax exemption intact.
As I said, that was a source of uncertainty in the first half, so the market was really relieved that the tax exemption was unscathed. But on the other hand, we had Medicaid cuts, and that, we believe, will present headwinds for hospitals, especially those in rural areas. There is some support, some funding for 50 billion to support rural hospitals, but overall, if you look at the longer term, we do expect a take-up in uncompensated care levels, which would affect hospitals negatively.
And even though the cuts are somewhat back-loaded, but the access to market and spreads probably will reflect it sooner. So, we are still cautious amongst all the sectors that we cover, major sectors. We do have a slightly mixed view of the sectors outlooks, especially reflecting the fact that, you know, CapEx has been strong, has been elevated post-pandemic, and some of the margins may come under pressure because of the economic slowdown.
But overall, credit quality continues to be robust, except one sector, hospitals, where we have a cautious outlook, and for the reasons I just mentioned. In terms of sectors and our preferences, we prefer revenue bonds over GEOs. You know, federal-state leaderships have been in the headlines, though, and could get more contentious in the second half, could drive some spread widening.
State GEOs have done well. Going forward, we like transportation sectors, utilities in particular, we're recommending airports and electrics as presenting good value opportunities. So, overall, it's a very constructive setup for the second half.
Yields are high, the curve is steep, long-end ratios, muni treasury ratios are neutral to attractive, so there is a lot to like in munis starting from here in the second half. Over the longer term, you know, 12 months out, these tax equivalent yields will drive attractive performance in our view, you know, fueled by the higher carry. And talking about long-term, in the spotlight section, and we've gotten questions about this from advisors as to who should buy munis, and on the long-term analysis with respect to investors' tax rates, who should find munis more attractive, and we do a break-even analysis in the spotlight, saying that at what tax rate is the muni index tax equivalent yield equal to the investment-grade corporate yield, and that break-even is 21 percent, but it suggests that investors above that break-even, from a long-term perspective, would find munis attractive to investment-grade corporates, and that break-even is amongst the lowest in the last decade, so suggesting munis have a very wide appeal right now across investors in different tax brackets.
So, to summarize, first half was disappointing, duration underperformed, essentially. Second half, stronger performance, better demand-supply balance, treasury volatility still, possibility of that still elevated, inflation could pick up, given all those things, but the curve is steep, and tax equivalent yields are attractive, given that we still maintain our barbell preference, up 3 to 7 in 17 to 30 years in the curve, still prefer higher quality credit, single A's look good, I think we are past our peak policy uncertainty, there is ongoing tariff uncertainties that the market has to deal with, but there has been progress in some of the trade deals, and there has been the signing of the one big beautiful bill, takes at least some policy angst off the table. So, a good constructive setup, we suggest investors take advantage of these yields, get invested, and look at the curve for opportunities at the short and long end, and focus on high quality bonds.
So, with that, Dan, let me turn it back to you. Well, Sadiq, thank you very much for dropping by Top of the Morning today, spending some time with our listeners, our clients, to lay out your outlook for the municipal bond market in the second half of 2025. Again, Sadiq has been making reference to the Mid-Year Outlook Municipal Market Guide piece, that title, again, The Better Half, is available now up on UBS.com forward slash CIO.
For clients of UBS, please reach out to your UBS financial advisor if you would like to receive a copy of the latest Municipal Market Guide directly. Though, again, we've been joined today by Sadiq Murkherjee, Fixed Income Strategist Americas from the UBS Chief Investment Office, and from UBS Studios, I'm Dan Cassidy. Thank you for joining us.
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