What’s Driving the Muni Bond Market Rebound in Late 2025?

When I last wrote about municipal bonds, they were experiencing a bit of a rough patch. In the first half of 2025, the Morningstar US Municipal Bond Index logged a slightly negative total return. It underperformed the Morningstar US Core Bond Index, which represents the market for investment-grade taxable debt, by roughly 4 percentage points. That’s a meaningful margin in the land of fixed income.

Tax-exempt bonds have staged a comeback in the year’s second half. Since July 1, the Morningstar US Municipal Bond Index has outpaced its taxable equivalent. For muni-bond investors, the year is shaping up to be disappointing but far from disastrous.

Bonds issued by US states, territories, and government entities serve as core portfolio holdings for many investors, including me. The appeal of tax-free income has attracted nearly $1 trillion of investor capital into municipal-bond funds, according to Morningstar asset flows data. As the year draws to a close, I thought it’d be worth digging into the short- and longer-term dynamics of the muni market.

A Volatile Period for Municipal Bonds

When I interviewed municipal-bond fund managers from T. Rowe Price in November 2024 for Morningstar’s The Long View podcast, they said the pandemic brought an abrupt end to a period of tranquility in the tax-exempt market that stretched back to 2015. In early 2020, panic selling caused a rout. While Treasuries were benefiting from a flight to safety, concerns over the creditworthiness of municipal-bond issuers amid societal shutdown drove down the prices of tax-exempt bonds. The Federal Reserve even stepped in to calm the muni market—an unprecedented intervention, according to my colleague Elizabeth Foos.

Since then, munis have taken a bumpy ride, but then again, so has the overall bond market. The Morningstar US Municipal Bond Index declined more than 9% in 2022, when stubbornly high inflation prompted the sharpest interest rate hikes in a generation. While painful, that loss wasn’t as severe as the more interest rate sensitive Morningstar US Core Bond Index, which fell 13% that year. Of the two indexes, the municipal-bond benchmark has been more volatile, though the difference is small. Municipals boast superior returns since 2020.

Coming into 2025, munis faced several headwinds. One was policy uncertainty, which my colleague Paul Olmsted wrote about in Is the Tax-Exempt Status for Municipal Bonds at Risk? Not for the first time, a new US president and Congress cast doubt on the future of the tax exemption. Beyond that, valuations, heavy bond issuance, and investment flows contributed to muni’s poor performance in early 2025.

Flows have undoubtedly played a role in the comeback as well. The Federal Reserve’s first rate cut of the year, in September, seems to have ignited investor enthusiasm for bonds. October 2025 saw the largest monthly inflow into both taxable and tax-exempt fixed-income funds since 2021. Strong September jobs data and improved valuations were further boosts to munis. So too was the passage of the Big Beautiful Bill, which preserved the tax exemption.

Staying the Course With Munis

The municipal market’s 2025 rebound is not without precedent. In 2020, the Morningstar US Municipal Bond Index finished the year with a 5.3% gain after losing more than 2.0% for the first five months of the year. Investment performance can change rapidly, even with bonds. It’s important for investors to maintain a long-term perspective and not panic over short-term fluctuations.

From an income perspective, the Morningstar US Municipal Bond Index throws off a yield of near 4%. That compares favorably with the Morningstar US Core Bond Index’s 4.25% yield given the tax exemption. Muni investors talk in terms of “tax-equivalent yield.”

This year is further proof that the taxable and tax-exempt US bond markets can diverge. I recently wrote about how heavy Treasury issuance has left the core bond universe with more interest rate sensitivity. It has also raised concerns around debt, deficits, and inflation at the Federal level. Munis, for their part, come with their own set of more local risks. Bankruptcies in Orange County, California, Detroit, and Puerto Rico remain seared into the memories of long-term muni investors.

But I don’t see why a well-diversified allocation to munis can’t serve as a core bond allocation. Beyond their tax-free income, munis offer similar diversification benefits as high-grade taxable bonds. Some years they will outperform their taxable counterparts, and in other years, they’ll lag. While 2025 may fit into the latter category, municipal-bond investors can end the year with a tax-free smile.