Top of the Morning: Municipal Market - Looking good at halftime
The desk is optimistic about the municipal bond market for the second half of 2026, building on the strong performance observed in the first half amidst various headwinds. Per the full note from UBS's Chief Investment Office, municipal bonds have outperformed other fixed income assets, showing lower volatility and strong demand. With tax-equivalent yields for in-state bonds in California and New York at approximately 7.6%, the desk suggests that attractive yields combined with stable credit quality reinforce a constructive outlook for the sector. However, macro risks, including geopolitical tensions and rate volatility, are potential short-term challenges that could impact market dynamics.
What the desk is arguing
The desk frames this as a critical juncture for municipal bonds, which have demonstrated robustness in a challenging environment. Following their outperformance against a backdrop of rising supply and geopolitical uncertainties, the desk expects this trend to continue into the latter half of 2026, supported by appealing yields and strong demand from high-tax bracket investors.
Key data indicates that the benchmark tax-equivalent yield for select states remains highly attractive—around 7.6% for California and New York. This yield is particularly appealing given the relatively stable credit quality observed in the municipal space, suggesting that investors may continue to find value here despite the headwinds.
Where it sits in our coverage
Our consensus target for the municipal bond outlook stands at 1.075, anchored by a range from 1.04 to 1.12. Key players reveal the following targets:
This outlook aligns with the bullish sentiment from jpmorgan while diverging from the conservative stance of bofa, placing our perspective slightly higher than the market's lower bound.
How other firms see it
Similar to our desk's view, the jpmorgan and benjamin firms are aligned on a positive trajectory for municipal bonds based on the yield dynamics. Conversely, bofa appears more cautious, maintaining a conservative stance due to potential rate volatility and geopolitical risks.
In terms of related market indicators, watch the performance of U.S. Treasuries closely, particularly the 10-year yield, as it will directly affect the pricing and attractiveness of municipal bonds moving forward.
What the calendar says
With no immediate high-impact calendar events upcoming, the focus remains on the ongoing geopolitical landscape and domestic economic data releases that might influence the yield curve.
01Municipal bonds have outperformed most U.S. fixed income assets in H1 2026.
02Tax-equivalent yields in high-tax states like California and New York are around 7.6%.
03Despite challenges, the outlook for municipal bonds remains constructive amidst stable credit quality.
Market implications
Investors should closely monitor the 10-year Treasury yield, which the desk anticipates will decline by year-end, potentially bolstering municipal bond pricing. Additionally, positioning ahead of any shifts in geopolitical dynamics will be crucial to gauge potential impacts on the municipal market.
Risks to this view
The outlook for municipal bonds could be invalidated by renewed geopolitical tensions or significant shifts in treasury rates that lead to increased volatility in the fixed income market. A destabilization of credit quality due to economic factors could further challenge this bullish view.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will focus back in on the municipal bond market and spotlight for you the latest municipal market guide publication from the UBS Chief Investment Office.
The title for this month, Looking Good at Halftime. Joining me here for today's episode, glad to welcome back from the CIO Municipal Research Team, Sadiq Mirkoji, as well as Janine Lennon. So with that, Sadiq, Janine, thank you both for dropping by today to spend some time with their listeners and their clients.
Sadiq, let me pass it over to you to get things started. Good morning. Thank you, Dan.
Let me just summarize the muni performance in the first half of the year. That's a good story. Despite heavy supply, geopolitical risks, rate volatility, munis outperformed most other U.S. fixed income assets to date, and that too with lower volatility.
So that's a good story, still looking good though, despite that outperformance. Tax equivalent yields are still attractive, especially for investors in the highest tax brackets. Demand remains very strong, we'll talk about that a little later, and credit quality is stable.
As an example, the tax equivalent yield for in-state bonds in California and New York for investors in the highest tax brackets are at around 7.6%. That's a very attractive level. So overall, munis have performed well, despite some headwinds, and yields still continue to look attractive.
In that backdrop, we maintain a constructive outlook for munis in the second half as well. Although renewed U.S.-Iran strikes, rate volatility risks could pose some near-term challenges. Let me talk about the macro environment first before talking about munis in the second half.
Rates play a large role in the performance of munis, and we do expect the 10-year treasury yield to decline by year-end. However, near-term rate volatility and treasury curve steepening are key risk factors. To date, the treasury curve has flattened significantly, and we think that may have gone a little too much, and re-steepening may be in order.
In contrast, the AAA tax exempt curve remains very steep. The 10-30 year is at around 126 basis points, after flattening by about 20 basis points in the 10-year, and the 2-10 year munis slope has steepened. So given that dynamic, the belly of the curve underperformed year-to-date, as issuers shifted supply into that part of the curve, and consequently, a barbell strategy has outperformed.
That brings me to duration positioning. The 20-year area continues to be attractive for absolute returns, with longer investment horizons. Demand is strong.
Yields are high. However, as I said, from a near-term perspective, we now moderately favor a lower duration. Munis have returned in the wings, particularly, so we close out our barbell.
The barbell trade has largely played out, and we now favor the 1-10 year on the curve. This change has been done after the MMD was published, in the wake of the renewed Iran-U.S. conflict. So a little, moderately shorter duration of about four years, effective duration, looks to be in order from a tactical perspective.
We like the 5% coupon bonds, and we might change that preference should yields go higher. Talking credit, credit fundamentals remain very strong. Upgrades have actually exceeded downgrades for the Muni market index over the past 12 months.
We expect credit quality to remain stable, as economic growth is expected to be at near trend this year. We do expect some good flowing in the second half, but overall, for the full year, we expect a near trend growth. Credit spreads are moderately tight, and we continue to recommend an overweight on the single A's relative to the index, but a small allocation to triple B's as well.
From a sector perspective, we like airport bonds. They perform well, but we also add some allocations to states and prepaid gas bonds, that last sector having shown a tremendous amount of issuance increase year-to-date. So overall, and from a sector perspective, we do remain cautious on lower-rated bonds of small, not-for-profit hospitals and colleges.
So that, in a nutshell, is our view, so a constructive outlook for the second half, with some near-term rate volatility risks remaining. Let me pivot now to a topic which has occupied headlines for some time now, and that's property tax reform. And for that, let me get into the conversation, my colleague Janine Lennon.
Janine, good morning, and we've seen a lot of headlines on this topic of property tax reform, and there's a lot of questions on investors' minds as to what the implications of this might be, what the status of these reforms are, and credit implications on geos, school districts, and so on and so forth. So can you update us and provide some CIOs' views on this important topic? Certainly.
Thanks, Sudeep, and good morning to our listeners and Dan. As you mentioned, property tax reform is making headlines, becoming increasingly important for muni bond investors, with it gaining more attention recently as affordability pressures build for homeowners across the nation. As a result, this debate is now showing up more frequently in state and local policy proposals.
From an investor perspective, the issue is not necessarily whether tax relief is provided to residents and if it's good or bad, but rather how that relief is implemented, and whether any lost revenue is replaced with funding that is durable, predictable, recurring, and timely. So first, just to set the stage here, while most folks listening in pay property taxes on their homes, they're not as aware of where that money goes after it leaves their account. With less than 1% of state tax revenue derived from property taxes, property tax reform would have very limited direct credit impact for states.
And so the focus on credit quality implications and this conversation is really on local level governments. So with that, what are property tax revenues funds? Importantly, these revenues are the foundation or backbone of repayment for many local tax-backed municipal issuers, like you mentioned, Sudeep, and that includes cities, towns, counties, and school districts across the U.S.
They are also a core operating revenue source, producing more than 45% of local governments' own source revenues. If that revenue is reduced or eliminated without a credible replacement, issuers could face tighter budgets, reduced flexibility, and increased pressure on credit quality. In addition to providing a majority of local government revenue, property taxes have also been one of the most stable and predictable revenue sources for local governments historically.
That stability supports budgeting, discipline, capital planning, and confidence in debt repayment capacity. Now, if property tax revenue is replaced with more economically sensitive sources, such as income or sales taxes, for example, investors may need to account for greater revenue volatility during the downturns, and that volatility matters as an issuer may look healthy during an economic expansion but face sharper stress in a downturn if replacement revenues are more cyclical. Now, this can affect liquidity, reserve levels, capital spending, and rating volatility, and ultimately guide credit differentiation across issuers.
That may otherwise look similar on the surface. But now, going back to states for a second, while I noted that they do not necessarily rely on property taxes for funding, they still matter because policies implemented at the state level can potentially create downstream pressure. In this sense, local governments and schools can be more directly exposed because they often have fewer tools to raise alternative revenues or cut expenses quickly due to state mandates for safety or other types of required services.
For example, recently Florida governor and its legislature recently moved forward to pursue a constitutional amendment that would significantly reduce property taxes through a statewide referendum this November. If approved by 60% of voters, local governments could face substantial revenue losses unless the state or voters authorize alternative funding sources, and as one was not outlined, or proposed as part of the measure when it was placed on the ballot. And this is why investors should look not only at the direct effect of tax reform, but also at the intergovernmental funding flows and whether state-level decisions could create a secondary type of pressure for local governments.
As these proposals move forward, investors should really evaluate tax reform through two lenses, the revenue resilience as well as implementation risk, proposals that pair tax relief with recurring, economically diverse and reliable replacement revenues are less likely to create credit pressure. By contrast, measures that rely on temporary state aid, voter-approved backfills, volatile tax sources, or simply unidentified replacement revenues could increase uncertainty around liquidity, operating balances, and really the long-term fiscal sustainability. At the portfolio level, issuer selectivity remains important, and we favor governments that demonstrate conservative budgeting, diverse economies, strong reserves, manageable fixed costs, and constructive relationships among state and local leaders.
As tax policy becomes a more active part of the municipal credit conversation, revenue predictability and fiscal flexibility will be important differentiators across tax-backed issuers. The strongest credits will be those that can show investors a credible path to stable revenues, balanced budgets, and continued investment in public services and infrastructure. With that, thanks for having me on, and back over to you, Sudip.
Thank you, Janine. That was excellent, really comprehensive and deep insight into the rather important and evolving topic. But just to close out our overall view of communities, we still maintain a constructive outlook for the second half of the year.
First half of the year is outperformed most other U.S. fixed income assets. That was powered by very strong demand, meaning strong supply. And we expect that strong demand to continue, especially in the summer months.
Year-to-date inflows into muni funds are tracking to be the second highest in the decade. That's a key driver of performance. So over the summer, the demand remains strong.
So we do flag rate volatility and treasury growth steepening as risk factors. This morning, inflation came down surprisingly by a larger amount than that was expected. That's good news.
But despite that, inflation and rate volatility do remain risk factors. Credit is stable, and investors can still take advantage of those attractive tax-equivalent deals. With that, let me pass it back to you, Dan.
Okay. Well, Sadiq, Janine, thank you both again for dropping by top of the morning, again highlighting the latest Municipal Market Guide publication from the UBS Chief Investment Office. The title, Looking Good at Halftime.
This publication is now available up on ubs.com slash CIO. Though for clients of UBS, please reach out to your UBS financial advisor to receive a copy. From UBS Studios, I'm Dan Cassidy.
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