I received a piece of reader feedback after publishing For Investors Who Can Get Beyond Headline Risk, Opportunity Beckons in Bonds that was as actionable as it was succinct. “What about municipals?” wrote in a longtime Morningstar.com reader. Fair question. In an article focused on calendar-year returns for Morningstar’s fixed-income indexes, I had neglected the “tax-exempt” market.
The truth is, we at Morningstar are in the mode of thinking of municipals differently. We separate out “Municipal Bond” from “Taxable Bond” in our monthly analysis of asset flows and in research like the Morningstar Diversification Landscape Report. Muni-bond yields are lower because of their tax exemption, so they are something of a different animal.
That said, municipal bonds play a foundational role in many investor portfolios, including mine. In the previous article’s quilt chart depicting calendar-year returns for Morningstar’s fixed-income indexes, we compared wildly different investment types, from the fixed-rate Morningstar US Core Bond Index to the floating-rate Morningstar LSTA US Leveraged Loan Index. So why not examine the tax-exempt market through the lens of the Morningstar US Municipal Bond Index?
The way I view the below quilt chart, municipals are having a rough 2025 so far from a total return perspective, but they’ve performed decently in up and down markets of recent years. And tax-free income is a big selling point, unless we see dramatic policy changes.
Munis: A Vast Market and Resilient Asset Class
First, it’s important to acknowledge the scope of the muni-bond market. The Morningstar US Municipal Bond Index contains nearly 21,000 individual bonds. The fact that the entire universe of debt issued by US states, territories, and government entities spans more than double that number reflects its vastness and fragmentation. Index constituents include project revenue bonds related to clean energy in California and gas in Kentucky, New York transportation, and Texas water. You sometimes hear about investing in “infrastructure.” To the extent that’s about essential services and recurring revenue streams, municipal bonds can be considered infrastructure-related investments.
As is the case with taxable bonds, municipal-bond investing comes in different flavors. Morningstar maintains 17 different categories for municipal-bond funds. Many of them focus on a single high-tax state, such as California. At the national level, there’s short, intermediate, long, and high-yield.
When you compare the broad municipal market, as represented by the Morningstar US Municipal Bond Index, with the universe for investment-grade taxable debt, proxied by the Morningstar US Core Bond Index, you’ll see the former is longer-term in nature. Some municipal bonds have maturities of 30–50 years, which pushes out the duration of the index. Its lower yield is explained by the tax-exempt status of the income, which is especially beneficial for investors in high tax brackets. Muni investors talk in terms of “tax-equivalent yield,” which makes it more comparable.
Judging from the above quilt chart of calendar-year returns, munis look pretty resilient. The Morningstar US Municipal Bond Index has shown itself to be a bit less sensitive to interest rate changes than its taxable counterparts, despite its longer duration. It lost less than most of the taxable indexes in 2022, when the US Federal Reserve responded to generationally high inflation by jacking up interest rates seven times by a total of 4.25 percentage points, sending prices on existing bonds plummeting. It also underperformed the broad taxable market amid the pandemic rate cuts of 2020. In several years—notably 2015, 2017, 2021, and 2023—the municipal-bond index outperformed its taxable-bond counterpart. Munis’ stable underlying revenue streams provide some protection from economic downturns that hit bonds with more credit risk, like bank loans, high-yield, and emerging markets.
So far, 2025 has been a rocky year for munis. The Morningstar US Municipal Bond Index was in negative territory for the year as of this writing. My colleague Gabe Alpert explains the poor relative returns as “a combination of stepped-up bond issuance, lofty starting valuations, and fund outflows.” The municipal-bond market is widely considered to be “retail” in nature, heavily driven by sentiment.
Beyond short-term swings, it’s important to note that municipal bonds offer similar diversification benefits to their taxable counterparts. As my colleague Christine Benz and her co-authors on the Morningstar Diversification Landscape Report have pointed out, inflation and rising interest rates helped turn correlations positive between munis and equities, just as they did on the taxable side. Correlations are dynamic, though. Investors can use investment-grade munis the same way they would a core bond allocation. They damp portfolio-level volatility and provide income.
How Does the Future Look for Munis?
My colleagues on the Manager Research Team who analyze and rate managed strategies focused on municipal bonds provide valuable insight into the asset class. For instance, Morningstar’s Paul Olmsted recently addressed an investor FAQ in Is the Tax-Exempt Status for Municipal Bonds at Risk? He concluded that “any change to the tax-exemption on municipal-bond interest appears unlikely.”
I also found Municipal Bonds: Where to Find Opportunities in a Volatile Market by Elizabeth Foos enlightening. Foos explains the muni/Treasury ratio, which compares yields and is used as a valuation tool. According to the measure, munis were not especially cheap relative to Treasuries coming into 2025, one of the factors for underperformance cited by Alpert above.
Further, I’ll mention an interview I conducted last year for Morningstar’s The Long View podcast with Jim Murphy and Charlie Hill, who manage municipal-bond portfolios for T. Rowe Price. They characterized their investable universe as “a very, very high-quality market with a very low default rate.” Admitting that the past few years, especially 2022, have been difficult for muni investors, they noted that rates are at 10- to 15-year highs. This means yields for investors that exceed the inflation rate. Naturally, Murphy and Hill argue that investors are better off getting their municipal exposure through professionally managed funds as opposed to individual bonds. Such management can help navigate tricky pitfalls like the de minimus rule, which can lead to “tax traps.”
Judging from the quilt chart, the Morningstar Municipal Bond Index’s calendar-year returns don’t look drastically different from a core taxable-bond portfolio. Performance can diverge, but it tends to be directionally similar. As a result, it’s fair to say that, as with investment-grade taxable fixed income, municipals can play an important portfolio role—for income, total return, and diversification.
