Treasury Market Volatility's Impact on the Muni Market

It was quite the week in the Treasury market last week, which was influenced by multiple factors: sticky inflation expectations, the Federal Reserve's (Fed) patient stance, rumors of foreign buyer boycotts, hedge fund deleveraging, portfolio rebalancing from bonds to cash, and overall Treasury market illiquidity. The situation was exacerbated by a notably weak 3-year Treasury auction, where the Treasury Department had to offer higher yields to attract demand — which still fell short of expectations. At its peak, the 10-year Treasury yield surged by over 0.70% last week before partially recovering to end the week "only" 0.60% higher. As is often the case, these Treasury market disruptions quickly rippled throughout the broader fixed income markets.

Conceptionally, non-Treasury bond yields are a function of a Treasury yield component plus a spread component to compensate for additional risks (including credit and liquidity, to name a few important risks). So, as Treasury market volatility erupted last week, most other high-quality fixed income markets were negatively impacted as well, with the muni market, perhaps surprisingly, feeling the brunt of the Treasury market volatility.

While investment-grade corporate bond yields increased by nearly 0.50%, the municipal market saw yields rise by 0.65–0.85% across various points on the curve. Most of the yield increase stemmed directly from Treasury market movements, but municipal bond spreads also widened considerably. Investors appeared to be selling liquid holdings in an attempt to seek refuge in cash until volatility subsided. However, the municipal market's inherent illiquidity and fragmentation made this mass exodus particularly disruptive, amplifying spread widening beyond what might otherwise be expected.

Even before the Treasury volatility episode last week, munis had been underperforming taxable markets this year. Underperformance was mostly the result of onerous net supply, ETF outflows, and headline concerns about the removal of the tax-exemption status of munis.

Regarding the tax-exemption issue, the House Municipal Caucus — which enjoys broad bipartisan geographic representation from Republicans in both solidly red districts (Indiana, Texas) and purple districts (Pennsylvania, New York, California) — continues to push back against proposals to eliminate this feature. While total removal of the tax exemption is estimated to raise approximately $250 billion over 10 years, the secondary effects would likely increase borrowing costs for municipalities by 0.80–1.0% for higher-rated issuers and 1.0–2.0% for lower-rated issuers. Although outright elimination appears unlikely, the heightened media attention surrounding this possibility has understandably dampened market liquidity.

That said, in our view, fundamentals for most municipalities are still in good shape, so while we could see downgrades increase marginally, we don’t envision a scenario where the recent volatility turns into something worse. So, once the volatility subsides, we would expect muni yields to fall, although uncertainty could keep yields relatively higher. In other words, so far, we think this is a volatility event and not a credit event.

On the positive side, starting yields remain quite attractive. With tax-equivalent yields (TEY) ranging from 7–9% (the high-quality Bloomberg Municipal Bond Index has a 7.24% TEY), we believe the value proposition for municipal bonds — particularly in the intermediate maturity category — remains compelling, though near-term volatility may persist.

Tax-Equivalent Yields Remain Attractive

* Assumes tax rate of 40.8%
Source: LPL Research, Bloomberg 04/11/25
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Moreover, municipal bonds currently compare favorably versus both Treasuries and corporate bonds. Measured through yield ratios — the municipal yield divided by Treasury or corporate yield of similar maturity — we’re noticing valuations that suggest attractive entry points.

The municipal-to-Treasury ratio has averaged around 65–85% historically, meaning municipalities typically yield about 65–85% of what comparable Treasuries yield before accounting for tax benefits. Current ratios stand notably above these longer-term averages, indicating municipals are currently relatively inexpensive — and not just for high tax bracket investors.

The municipal-to-corporate ratio tends to be lower (typically 60–65%) since corporate bonds carry elevated default risks and thus should offer higher yields compared to municipals. This current spread is above longer-term averages as well. These favorable relative valuations suggest potential for increased “crossover” interest from non-traditional municipal investors, which would help support prices going forward.

Munis Are Cheap Compared to Treasuries and Corporates

AAA Muni Yields vs. U.S. Treasury Yields

AA Revenue Bonds vs. AA Corporates

Source: LPL Research, Bloomberg 04/11/25
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

No doubt last week was a volatile week in the fixed income markets. But the positive news is that higher yields and wider spreads typically translate to better future returns. For investors willing to maintain their positions, bonds provide certainty that many other financial markets don’t. Those who hold bonds to maturity will find that this volatile episode, while uncomfortable, won't impact coupon payments or principal repayments at par — especially for Treasury securities. Furthermore, the Treasury market remains one of the world's most critical financial markets. We're confident that Fed and Treasury officials won't stand idly by if conditions continue to deteriorate. While there's currently no indication that the Fed is preparing to intervene, one of its key mandates is maintaining financial stability. And with bond markets experiencing significant disruption, we believe the recent price action has certainly captured the Fed's attention, which should ultimately help the muni market as well.