The last time municipal yields traded this wide relative to Treasuries was in the fall of 2023.

Municipal new issuance momentum carried into the new year. After eclipsing $500bn for the first time in 2024, first quarter 2025 issuance of $120 billion exceeded last year’s tally by 20%. Many issuers accelerated deals last year to front run potential election-induced volatility. This year, issuance is being pulled forward to get ahead of legislative changes. Up until mid-March, the new supply was easily absorbed, and investor sentiment remained positive, reflected by $1 billion in average weekly inflows. Only time will tell whether the late-quarter weakness portends a broader trend.

Despite all the political noise and market volatility, our intermediate portfolios ended the quarter with modestly positive returns, both on an absolute basis and relative to our benchmarks. In general, the outperformance of low rated credit and the outperformance of short maturities as the yield curve steepened detracted from our relative results. We typically de-emphasize traditional short maturity fixed-rate municipals in favor of floating rate notes and zero-coupon bonds, which also lagged. Our portfolios’ yield advantages and the performance of our Freddie Mac and Fannie Mae-backed multi-family housing bonds offset these factors. By trading convention, many of the multi-family related bonds we own tend to track Treasury performance even though they pay tax-exempt interest. As Treasuries outperformed municipals, these bonds benefited significantly.

Ending the tax-exempt status of municipal bond income has been mentioned as an option to offset some of the cost of the Tax Cuts and Jobs Act (TCJA) extension. It will surprise no one that we think this is a bankrupt idea. As we learned from the Build America Bond experiment in 2009 and 2010, taxable bonds usually find their way into exempt accounts such as IRAs, endowments, or overseas portfolios that offer no benefit to domestic tax collections. With that said, we believe it likely the municipal market will be altered in some way. Several administrations dating back to Nixon tried to reform the municipal market. The Reagan tax cuts altered the taxation of private activity bonds. President Obama also floated capping the tax benefit on municipal bonds at 28%. The first Trump tax cuts eliminated tax-exempt advanced refundings. We derive comfort from the fact that while many presidents have tried, we are still here offering our clients substantial tax-advantaged income.

The new administration has announced several plans that could have large impacts for the municipal bond market. From a credit perspective, our primary concern relates to spending cuts to help offset the effect of extending the TCJA. Based on the current budget blueprint, Medicaid appears to be the primary target, facing $880 billion in spending reductions over 10 years. The healthcare sector has faced numerous challenges over the past few years and reductions to federal funding will slow, if not reverse, their recovery. A reduction in Medicaid coverage would result in lower revenues and lower collection rates. We have positioned cautiously in the hospital sector as risk-adjusted yields generally fall short of our requirements. We also expect higher education to be affected, but our exposure is limited for similar reasons. On the table are proposed cuts to research funding, restrictions on tax-exempt bond issuance, and an increase in the endowment tax. We believe these challenges are manageable with prudent financial planning.

Up until the recent election, municipal credit had broadly benefited from federal fiscal largesse, but changes are looming. Traditional credit valuations still reflect a “priced-to-perfection” world. This implies not only a hope that fundamentals will stay strong, but also that investor greed persists to squeeze every basis point of yield from the market. We prefer to be more selective. Staying flexible and building portfolios one bond at a time with high-quality credits that provide attractive yield is at the heart of our mission. Despite low spreads on bonds with generic structures, during first quarter 2025 we invested in a wide range of opportunities with less traditional structures that offered healthy spreads. These purchases enhanced existing portfolio exposures in prepaid energy, housing, and airport bonds, among others.

Specifically, we purchased prepaid energy bonds backed by the regulated insurance arm of Athene at a spread of over 150 bps. This is well beyond our purchase threshold and wider than Athene’s structurally weaker holding company’s taxable corporate bonds. We added Freddie Mac-guaranteed low-income, multifamily housing backed bonds with spreads between 80 and 140 bps, depending on maturity. We also invested in a range of State Housing Finance Authority bonds with four-to-six-year average lives and spreads around 100 bps versus generic triple A-rated municipals. Lastly, we added a new position in Los Angeles International Airport (LAX) late in the quarter. Airports represent about 15% of our portfolio holdings, and our airport credits often benefit from near monopoly power. Furthermore, LAX has among the best carrier diversity of any airport in the United States, which means it is not overly reliant on service from one airline, and it also enjoys strong liquidity.

We remain excited about the income potential of our portfolios and the opportunities on offer but remain cognizant to the risk that markets could once again come undone. There is no shortage of economic and political uncertainties that could lead market conditions to change suddenly. Our job is not to predict these changes, but rather to react appropriately and capitalize on them. Investors’ positive sentiment will eventually turn, and we are likely past the high-water mark for credit, so we are staying on our toes. With longer-term yields nearing their peak of 2023, the municipal market offers compelling value for our clients. We strive to stay blind to the distractions from the hope and fear outside and remain focused on finding securities that satisfy our conservative investment criteria.