The Federal Reserve’s interest rate cut forecast may not be as generous as fixed income investors had hoped, but the tax-exempt municipal bond space will continue to offer a solid deal in the new year. The central bank has dialed back interest rates three times in 2024, but policymakers only see two more reductions in the new year. That’s down from four they had predicted in September. “There’s a lot of uncertainty out there on the path for rates going forward,” said Paul Malloy, head of U.S. municipals at Vanguard. “When I think about that, what’s the best asset that provides great income and ballast? The answer is muni bonds.” Financial advisors have been turning toward municipal bonds this year, using them to add duration – that is, exposure to bonds with longer maturities and greater price sensitivity – in the hopes of seeing a bump in prices as interest rates come down. Bond prices and yields move inversely to one another. In a diversified portfolio, munis also offset stocks’ volatility. These bonds are especially attractive for high-income investors, particularly those who reside in high-tax states like New York or California. That’s because muni bonds spin off interest income that’s exempt from federal tax – and they tend to avoid state and local taxes if the investor resides in the issuing state. Rate policy isn’t the only thing investors should be watching going into the new year. With the Trump administration taking the reins in January, tax policy is back in focus. A slate of provisions in the Tax Cuts and Jobs Act is expected to expire at the end of 2025. “Look at 2025,” said Eric Golden, founder and CEO of Canopy Capital Group. “There’s a lot of opportunity, but also a lot of volatility as changes get rolled out.” Governments in focus The Tax Cuts and Jobs Act, which took effect in early 2018, roughly doubled the standard deduction, adjusted individual income tax brackets , lowered most of the rates, and applied a $10,000 cap on the state and local tax deduction (known as SALT). With a Republican sweep in both chambers of Congress and the White House, there’s a chance that lawmakers could extend these expiring provisions, a move that could unfold in the back half of 2025, Bank of America municipal research strategist Yingchen Li wrote in a report earlier this month. While an outright elimination of the cap on the SALT deduction could prove too expensive, lawmakers could opt to raise the $10,000 limitation. For instance, those filing jointly might see the cap rise to $20,000, Li said. A change like this could reduce demand for tax-exempt munis, the strategist noted. Bear in mind that it’s still too early to say what this legislation might look like. On the state and local side of things, the picture remains rosy. Malloy of Vanguard points to a “muni bond trifecta for 2025,” a combination of attractive yield, strong muni fundamentals, and solid rainy day funds for state and local governments. A strong economy and solid wage growth are also contributing to the outlook. “Credit still looks pretty attractive in the municipal space, alongside muni fundamentals that are in very good shape,” he said. Seeking opportunities In the muni bond space, investors who can stomach price volatility could be rewarded by taking on issues that have longer maturities. “I like the long end [of the municipal yield curve] because unlike the Treasury curve, the muni curve has some slope to it, and it’s steeper than the Treasury curve,” said Malloy. Indeed, the best-performing spot on the muni curve is 20 years with a total return of about 5.3%, according to a late November report from JPMorgan. “The average return in 15-25yrs is projected to be a solid 5.2%,” wrote Peter DeGroot, head of the municipal research and strategy team at JPMorgan. “Our analysis suggests that the weakest average returns will be found in 1-5yrs at ~3.3%.” There are still options for investors who may not have the nerves for sharp price swings: the shorter end of the yield curve. Shorter-duration bonds offer income, but their prices aren’t as sensitive to fluctuations in rates. “The broad macro monetary policy narrative is a pause in rate cuts,” said Malloy, who noted that there is sufficient yield in the front end of the market to offer investors “lots of carry cushion.” Indeed, Vanguard recently debuted its Short Duration Tax-Exempt Bond ETF (VSDM) , an actively managed offering with an average duration of 2.7 years and an expense ratio of 0.12%. The firm also offers the passively managed Short-Term Tax-Exempt Bond ETF (VTES) , which has an average duration of 2.4 years and an expense ratio of 0.07%. On the credit quality front, investors willing to take a little risk can see a bump in yields. A total return analysis performed by JPMorgan found that BBB-rated muni bonds beat their AAA counterparts by an average of roughly 1.8% across the curve. “Triple-B is an area that has been overlooked,” said Golden. “You have a ripe environment for spread and yield compression as yields have risen to an absolute level and spreads are less attractive for double-A versus triple-B.” Hunting for bargains, particularly in the BBB world, might be better left to fund managers rather than do-it-yourselfers, however. “It’s harder and harder to make a broad sector call,” said Malloy. “We like credit in general, triple-Bs, but there’s a necessity to be selective.”
