Top of the Morning: Munis 2026 Outlook - On a strong foundation
The desk's thesis focuses on a bullish outlook for the municipal bond market in 2026, underpinned by strong early performance and favorable macroeconomic indicators. Per the full note from UBS, the team projects total returns of around 5%, driven by attractive tax-equivalent yields and robust economic growth, potentially supported by a Federal Reserve interest rate cut in early 2026. This outlook stands in contrast with previous years where municipal bonds lagged behind other fixed-income assets, marked by a total return of just 4% in 2025. Consequently, traders might consider shifting positioning towards municipal bonds as the market dynamics suggest improved performance relative to treasuries and corporates.
What the desk is arguing
The desk posits a positive outlook for the municipal bond market in 2026, suggesting a total return of approximately 5% as conditions improve. According to UBS's municipal research team, the market is benefiting from favorable seasonal effects as they outperform both treasuries and corporates early in the year.
Key elements supporting this outlook include anticipated economic growth, with estimates slightly above trend line, and the expected impact of a Fed rate cut in Q1 2026. Investors may find the tax-equivalent yields appealing, particularly as the previous year’s performance demonstrated that munis still lagged behind other fixed-income securities despite a decent total return of 4% in 2025.
Where it sits in our coverage
In our coverage of municipal bond targets, jpmorgan has set a target of 1.10 for March 2026, while bofa holds a contrary view with a target of 1.04 for the same tenor. Overall, this places our desk’s outlook at the higher end of the existing forecasts.
How other firms see it
Firms aligned with the bullish sentiment include jpmorgan, while those contrarily positioned like bofa are projecting lower returns. The consensus amongst aligned firms points toward a favorable trend for munis, exhibiting a stark contrast to those firms anticipating weaker performance. Traders should also watch indicators such as the Fed's monetary policy shifts and economic indicators that influence municipal financing conditions.
01Projected total return for munis in 2026 is around 5%.
02Strong seasonal effects have led to early outperformance vs. treasuries and corporates.
03Anticipated Fed rate cut could further support growth in the municipal bond market.
04Investors should take note of attractive tax-equivalent yields.
Market implications
Traders should monitor the trajectory of municipal bond yields against treasuries, particularly around the anticipated Fed rate cut, which could create favorable conditions for munis. A decisive move above the 1.10 mark may trigger further buying interest, confirming the bullish outlook.
Risks to this view
A failure to see a Fed rate cut or unexpected economic downturns could negatively affect the municipal bond market. Additionally, a rise in treasury yields could erode the competitive advantage of munis, leading to underperformance.
ubs
Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
For our conversation today, we will focus in on the municipal bond market. We do have the CIO Municipal Research Team in the Americas joining us for the conversation today. They will be highlighting the Muti Market Guide.
The publication for the month of January focuses on a 2026 outlook for the asset class. And with that, we do have joining us today, Sadiq Murkherjee, Janine Lennon, as well as Ted Galgano, again from the CIO Municipal Research Team. So with that, Sadiq, Ted, Janine, thank you all for dropping by top of the morning today to spend some time with our listeners and our clients.
Sadiq, you're at the start. Let me pass it over to you. Good morning.
Good morning and Happy New Year, everyone. Thank you, Dan. So let me talk to Munis today and focusing on our 2026 outlook on a strong foundation.
So the good news first, Munis are off to a strong start in 2026. There is a bit of the January effect of favorable seasonals, but they're outperforming treasuries and corporates. So we started the year on a strong note.
Tax equivalent yields are attractive compared to treasuries and corporates. Total return performance in 2025, just to provide a brief recap, was around 4 percent, much better than 2024, yet Munis lagged other fixed income assets. We expect overall in 2026, we expect total returns to be around 5 percent and also convergence of performance with the other fixed income assets.
That's the broad backdrop of our expectation in 2026. But let's go through some of the some of the items that that investors should be aware of. And three key items are really important for this year.
The macro environment, supply trends and dynamics. So let me start with the macro. We have good news on the economic growth front.
We expect trend line growth, maybe a little higher than 2026. One Fed rate cut, maybe in the first quarter, certainly in the first half. And that the software labor market has has kind of helped bolstered that view of one rate cut, even though inflation is still above the Fed's target.
We do expect inflation peaking in the first half of the year and then settling down by the end of the year. So both of those things, labor market and inflation dynamics, are going to play an important role and also drive Treasury yields. We expect the 10-year Treasury yield to decline to 3.75 percent by the first half.
But obviously, those things don't go in a straight line on especially this year. Rate volatility, which is going to play an important role in the Muni market. Rate volatility has collapsed recently, but could very well return as geopolitical and fiscal risks remain elevated.
So coming on to supply, 2025 saw record supply. That increased supply trend started in 2024. It's a combination of several factors, aging public infrastructure, waning of pandemic-related funds, higher capex cost due to inflation, and federal policy uncertainties.
All of those factors are still applicable in 2026. So we still expect supply to be elevated in 2026. That said, there were some sectors, particularly school geos, which saw a very, very significant jump in supply.
Could supply pair back in all those sectors? Sure. But notwithstanding that, relative to historical averages, we expect supply to be elevated.
But the good news there is that we also expect robust demand and flows. Actually, in the aggregate over the year, we do expect demand from principal redemptions and coupon income to actually exceed supply. But those two are not usually synchronized in time.
So opportunities would emerge during periods where heavy supply coincides with weaker seasonal demand, fund outflows, and rate volatility. So those would be the times where investors can take advantage, in a tactical sense, of both duration and credit. Talking about duration, the AAA tax exempt curve is very steep compared to the Treasury curve and to its own history, especially in that 10 to 30-year area.
So as we all understand, the steep curve favors longer maturities, as you simply pick up yield by extending duration. So if you look at the whole year on an absolute return basis, it is those longer intermediate part of the curve that should produce the highest absolute total returns. And I'm talking about the 15 to 20-year, the 12 to 17-year.
That general part of the curve should offer the highest absolute total return. However, as we talked about supply and rate risks, we've begun 2026 tactically a little more defensively with a preference for the 3 to 7-year area of the curve. And that corresponds to a duration of around four years.
And that should help us attack opportunities as they arise in Q1 as supply ramps up. We're going to start getting a very busy calendar very soon. In terms of coupon structure, the 4s had really underperformed in the first half of 2025, had a strong rally in the second half.
The duration also got rewarded. The yield difference of 4s to 4s and 5s has narrowed. We generally prefer to have coupon bonds, albeit with a more balanced coupon mix in the portfolio.
And again, lower coupon opportunities would arise in the first quarter of 2026. Now, coming to the investment side of the business, we have seen in the spotlight section of our report, we highlight two fast-growing segments of the municipal market, separately managed accounts and exchange-traded funds. SMAs, or separately managed accounts, now account for more than a third of all municipal assets.
They've grown from a very small size 10 years back to being a dominant force in the muni market currently. And the reason for that growth is that they provide customization capabilities along several dimensions of investments, coupon maturity, duration, credit, so on and so forth, even though SMAs tend to focus on the 1 to 10-year so there is a bit of a demand mismatch at the back end. But overall, this is the engine of growth in the muni market and will continue to be so in 2026.
ETFs, much smaller but a very fast-growing segment, now account for the bulk of muni fund flows. And that's important because when you get this volatility, ETFs play a big role in fund movements, thereby investors can actually overlay some tactical positioning using ETFs. There's a variety of ETFs.
Active ETFs have grown recently, but ETFs are along the spectrum. They provide passive index, broad index-based market exposure, as well as more specialized exposure. Overall, as technology continues to reduce costs and boost operational efficiencies, both SMAs and ETFs can be a powerful combination to achieve better portfolio risk-adjusted outcomes, so more choice for the investors in short.
Coming to credit, fundamental credit quality remains very strong. In fact, if you look at the percentage of AAA and AAA bonds in the index, that has actually gone up from about 64% a few years back to almost 70%. So the index credit quality is very strong.
Although we think that that may be at or near the peak, and rating activity could moderate further in 2026. It did moderate in 2025. That won't drag down returns in any significant way, but that's something for investors to be aware of, that higher quality probably is better.
We prefer AAA to single-aided bonds, and we especially like the single-aids in terms of where their option-adjusted spreads are trading at in terms of their five-year range. In terms of sectors, we do favor revenue bonds over geos. You'll pick up there.
And at the same time, as I talked about, fundamental credit remaining strong, but probably near a peak in terms of ratings momentum. In the same breadth, sector credit outlooks are also somewhat mixed. And to talk more about sectors, and we cover a variety of sectors within MUNIs, I'm joined by my colleagues Janine Lennon and Ted Galgano.
So, Janine and Ted, welcome to the conversation. So, can you briefly discuss your fundamental credit outlooks for the various sectors? Certainly.
Thanks, Sadiq. A lot going on in MUNIs. In terms of MUNI credit coverage, I'm the lead analyst focused on states, local governments, and the public higher education sectors.
As everyone is very aware, these particular sectors are on the front line of public policy each and every day. They're inextricably linked to federal policy outcomes, given their reliance on federal funding and their shared objective of providing essential public service to residents. While their purpose is shared, their role in the hierarchical structure for federal funding is not.
It's this funding structure, in combination with each sector's fundamental credit abilities, that supports the differing outlooks. So, let me take a minute to walk through that. While states are the most exposed to federal cuts, with about a third of their budget supported directly by the federal government, they have the largest tax bases, strong taxing authority, control over their budgeting processes, ability to pause capital projects, and capacity to draw down reserves, which are close to all-time highs, to support their credit stability.
It's for these reasons that we have assigned a stable outlook for the state sector. With the public higher education sector largely supported by these strong and resilient state sector attributes, we have also maintained a stable outlook for the public higher ed sector. Now, that said, we will monitor if states reduce support for education as their balance sheets adjust to reduce federal support in the years ahead.
But as mentioned, we believe public institutions are well-equipped to manage these challenges due to strong demand and lower cost relative to their private school counterparts. Now, while we have assigned a stable outlook for states in the public higher ed sector, we have assigned a mixed outlook for local governments, given their outsized reliance on both state and federal funding, which stands to be reduced, combined with a more limited ability to raise revenues and cut expenses. Local governments also tend to serve smaller tax bases and more often require approval to raise taxes or create new tax levies under their respective state constitutions.
These attributes limit the revenue side of the equation, with expenses often being higher and fixed, sometimes resulting in budgetary and financial pressures. It's for these reasons we have assigned our mixed outlook for the sector. Now, with that, let me pass it over to Ted to cover some of the more revenue-supported sectors.
Ted? Thanks, Janine, and good morning, everybody. Definitely interesting to hear about how those three sectors are all interrelated, unlike the sectors that I tend to cover, which are toll roads, airports, water and sewer, electric, and private higher education.
While they all do benefit from some sort of a federal largesse that you've discussed, it's not nearly to the extent that your sectors rely on the federal government for funding. My sectors, by and large, also tend to benefit from the ability to control their own revenue streams, which is key, certainly, to their health and well-being. With that said, let's start with the transportation sector.
That consists of both airports and toll roads. CIO has assigned a stable outlook to the sector. It has clearly rebounded from the reduced travel demand that we all saw during the COVID era.
It now benefits from very strong liquidity, a robust economy that supports healthy travel demand, increasing revenue trends driven by both a combination of them charging higher rates, but also higher travel volumes, driving increases in revenue. While higher tariffs could lead to increased capital expenditures, could be a bit of a headwind, we believe the sector will remain resilient given its strong credit profiles. Its ability to align its projects and timeline with customer demand also is key, and its capacity to increase charges, as we discussed, to customers as needed really supports the sectors.
The utility sector, now moving along, which includes both electric and water and sewer services, has been assigned a mixed outlook, unlike transportation, which we consider stable. All right, headwinds for the sector include extreme weather. We've seen that, you know, sadly, the fires out in LA are a prime example.
Aging assets, EPA requirements, and rising capital and carbon transition costs for electric utilities in particular, and water scarcity issues for water and sewer sector remain. So, the cost of building resilient infrastructure and meeting the demands of AI-driven consumption, which we've all read a lot about, may increase leverage and rates, which could raise affordability concerns for the overall sector. However, we do continue to view, and I emphasize here, large utility providers as well-positioned, supported by sound financial metrics, rate autonomy, and highly essential services they deliver.
So, again, this is a mixed outlook because we do believe the large utility providers have the ability to perform well, where the smaller utilities, especially rural providers, are going to be, see greater challenges. Okay, and now finally, let's turn over and look at the public, no, sorry, private higher education sector. We've also assigned a mixed outlook to the private higher education sector.
Like the utility sector, we believe that scale is increasingly important, and these sectors are becoming more bifurcated between the haves and have-nots. When we're talking about private higher education, softer enrollment trends, a lot less kids graduating from high school, federal policy changes, which we've all read a lot about in the last year, will challenge smaller liberal arts colleges that lack national brand recognition and have weak demand characteristics. These small, expensive institutions with limited resources will face significant challenges and possible closures.
Conversely, selective institutions with strong national name recognitions and large endowments are clearly better positioned to weather policy-driven changes, including the endowment tax that was included in the one big beautiful bill last year, which CIO believes, you know, presents modest but very manageable challenges for those institutions that are impacted. With that, let me hand it over to Sudeep so he can discuss the not-for-profit hospital sector. Thank you, Denon, Janine.
That was an excellent overview of the various sectors. Let me cap up the sector discussion with a quick comment on not-for-profit hospitals. There we have a mixed outlook, as I think most investors, many investors know, hospitals do carry a high risk profile, although they also provide a higher yield.
In terms of fundamental outlook, the improved financial metrics should provide some more resiliency to the sector, although non-renewal of Affordable Care Act premium subsidies that's in the news, has been in the news, is a bit of a credit negative for non-Medicaid expansion states, especially Texas and Florida, two examples. The House just passed its three-year extension, but the Senate is unlikely to pass it, so we're still waiting on what kind of a compromise could be struck there. Medicaid cuts, as a result of the one big beautiful bill, will have some more limited impact in 2026, as most of the cuts begin in 2027, but clearly in the longer term, they're a headwind.
Credit bifurcation is the main theme in the sector. The large financially strong hospitals are much better positioned, especially those that are geographically diversified, to navigate challenges than small rural hospitals that should face substantial headwinds. There are some positive aspects.
The increased adoption of AI will boost productivity, but overall, the sector outlook is mixed. Let me now summarize just some overall comments on the municipal market for 2026. We believe munis are on a solid foundation as they have become in 2026, despite rate and supply risks and some mixed sector outlooks that we just discussed.
We believe munis will deliver safe tax-exempt income with attractive tax-equivalent yields, especially valuable to those investors in those highest tax brackets. So we believe munis will live up to their core value in 2026 and present many opportunities for good safe tax-exempt income for investors, especially those in the highest tax brackets. With that, let me turn it back to you, Dan.
Okay, well, Sadiq, Janine, Ted, thank you very much for dropping by top of the morning today to share with our listeners and their clients a 2026 outlook for the muni market and muni sectors. Again, we've been joined today by Sadiq Markerji, Janine Lennon, as well as Ted Galgano from the CIO Municipal Bond Research team, and as referenced, the muni market guide, which the team has been referencing the 2026 outlook note, is now available up on UBS.com forward splash CIO. Though for clients of UBS, please be sure to reach out to your UBS financial advisor to receive a copy of the latest muni market guide on a strong foundation.
Up again is available for you up on UBS.com forward slash CIO from UBS studios on Dan Cassidy. Thank you for joining us. Thank you for tuning in.
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