How muni credit and market conditions are shaping 2026 investment strategies

The attractive cash flows that have characterized much of 2025 have created a strong "carry" component to performance, providing an offset to the principal losses as well as offering defensive attributes against shifting credit conditions. In my opinion, municipal security allocations in 2026 could possibly be rewarded as the potential for total return performance is quite real given the likelihood of lower, yet still present, market volatility and reasonable prospects for booking further "carry" attribution, particularly on the long end. This would provide protection against episodic erosion of principal. Of course, both monetary and fiscal policies along with economic developments have the ability to be very impactful.

I expect continued net positive inflows as product demand by an expanding and shifting buyer base accelerates in 2026. Following on the heels of record issuance in 2025, record volume is again anticipated for 2026. While the supply backdrop may be an intermittent drag on performance, still-relevant yield and income opportunities and largely favorable credit conditions should drive investor interest in 2026.

With the accompanying backdrop in mind, I have put together some actionable ideas for 2026 that leverage key credit and market conditions:

• Quality-centric portfolios are advised to trade up and pursue a defensive shift in credit quality during periods of spread compression. Muni portfolio additions and realignment should be made with a disciplined eye toward quality and resiliency. Adherence to suitability needs and conservative investment guidelines should position portfolios defensively to mitigate potential shocks throughout a shifting monetary policy cycle and to prepare for economic weakness.

  Preserving credit quality is particularly important when spread differentials become more pronounced with weaker credits potentially exhibiting greater diminution in value. Consideration should be given to liquid issuer names that offer scale and those that demonstrate stable or improving credit metrics.

  Identify those credits that maintain consistent revenue performance, particularly during economic downcycles, and those that possess tax-rate flexibility and provide tax base and employment diversification, while avoiding those that show a disproportionate reliance upon one particular taxpayer or sector. These measures should help maximize portfolio returns, credit quality, liquidity, cash flow and diversification.

• Should disruption attach to the banking sector, be prepared to take advantage of corresponding spread widening on sectors of the muni bond market tied to bank credit quality, such as energy prepay transactions, and LOC structures. A broad tightening of credit conditions across the banking sector and/or isolated closures could create this scenario even though the financial counterparties to the muni transactions remain strong and viable. There is still outperformance to unlock in the gas prepay sector given continued income opportunities.

• Strategic duration extensions beyond 15 years may allow capture of curve outperformance should further episodic flattening appear on longer-dated tenors. Attractive tax-adjusted yields can help to shield portfolios against rising rates. Limited duration risk can be available on longer maturities given 10-year call structure, particularly as rates decline.

• Sector allocation, yield-curve management, best execution, and security selection with active fundamental credit analysis can go a long way toward investment performance as opposed to making bets on interest rates.

• Given the uncertain future of Medicaid reimbursement, shift away from disproportionately Medicaid-reliant hospital providers into more diversified payor-mix facilities that maintain strong balance sheets, comfortable operating margins, geographic diversification with a sound business footprint, and a well-defined mission statement. Existing tightness of healthcare spreads can help to facilitate the shifts.

• Given the swelling competitive forces within the higher education sector, active buyers in this space should focus on those institutions possessing brand recognition, a strong and nimble balance sheet, adequate revenue diversification, a competitive footprint and a differentiating menu of academic offerings.

• As a way to guard against the uncertainties of monetary policy, minimize interest rate risk, and support duration management, adoption of a "barbell strategy" may offer protection by weighting a certain allocation of bonds on the short end and placing an additional commitment on the long end. Under this strategy, investors can (1) add protection on the short-end should interest rates rise, thus reducing reinvestment risk, and (2) lock in higher long-term returns if interest rates decline.

Muni performance staged a comeback during the second half of 2025

Once the shroud of uncertainty over the muni tax exemption was lifted at midyear, muni performance broke free and moved out of the red to conclude the third quarter decidedly positive, with the broad market index completing 2025 with returns well in excess of 4%.

Although munis played catch-up with other fixed income asset classes, they finished the year underperforming both Treasuries and corporates, but still with respectable returns. Although munis may continue to underperform within fixed income, I suspect that the performance gap could reveal noted tightening, and should technicals and flows go into overdrive, there is certainly room for outperformance. Entering the new year, I am expecting sub 5% returns.

In my view, had it not been for the dark cloud of tariffs and the tax-exemption during the first half of 2025 creating a technical dislocation, with accompanying liquidations, outsized bid-wanted lists, and price discovery, munis could have outperformed 'Treasury securities even as the Fed was lowering short-term rates. The lingering threat over the tax-exemption, albeit largely perceived, forced munis to distance themselves from Treasuries, which generally tend to reveal more front-line reaction to economic developments as well as to most fiscal and monetary policy events than do munis.

Although munis typically underperform Treasuries during periods of falling interest rates (due to call options and reinvestment risk), as previously mentioned, inflationary concerns, monetary policy divergence and fiscal policy uncertainty can lift long-dated bond yields.

Following historically strong muni performance in October, November 2025 was a good month for fixed-income performance with falling interest rates boosting returns. Corporate bonds saw particularly strong performance for IG and HY as credit spreads tightened thanks to tech/AI-driven support. Treasury performance was led by strong returns on longer-duration bonds given expected Fed easing.

Muni performance was highlighted by duration extensions pursuing compelling long-end opportunities with historically steep curves, yet trailed both corporates and Treasuries. The emergence of long-end curve flattening in September and into October in anticipation of Fed rate cuts, which created a widening in short-end yields coupled with a rally on long dated maturities, drove strong outperformance along that part of the curve.

Despite fixed income displaying positive December returns leading into Christmas, munis continued to underperform with negative returns given heavy supply conditions and softer demand accompanied by smaller inflows earlier in the month. However, the asset class still offered yield and income attributes, decent relative value, and compelling taxable equivalent yields. I believe that without such heavy issuance, the performance gap between munis and Treasuries would have likely been much tighter.

Looking at late-December returns, the 7- to 10-year maturity buckets were outperforming year-to-date, likely due to heavy SMA interest. General obligation bonds performed comparably to the revenue bond index, the "A"-rated bucket modestly outperformed on IG quality and high-yield underperformed for the year. These results showed tighter performance divergence relative to 2024, which may be due to curve steepening conditions with attractive long-end benefits.

Although high-yield munis, which outperformed the broader muni index earlier in the year, lagged IG in 2025, historically elevated income became available on HY given wider credit spreads creating more desirable entry points. I suspect that limited taxable advance refunding volume in 2025 contributed to the significant taxable outperformance.

Relative value was compelling enough

Throughout 2025, relative value ratios (M/T) demonstrated some volatility. While they remained closer, yet still higher, to the historically tight levels of 2021, they were lower than their longer-term averages over the past 40 years, but much closer to their five-year averages. Although ratios became attractive (i.e., cheaper) during the spring when munis sold off, they grinded tighter (i.e., more expensive) in the fall. Throughout much of 2025, particular value was found on the long end of the muni curve, allowing investors to capture absolute yield opportunities and compelling taxable equivalent yields.

Given the more visible steepness of the muni curve relative to the Treasury curve, a more substantive yield pick-up was available for those investors willing to extend duration. Again, muni yields were driven higher by the concerns over the future of muni tax exemption and record issuance. Product demand in the second half of 2025 accelerated as higher-yielding assets in a declining rate environment gained attraction. I expect similar ratio patterns to emerge in 2026 given anticipated demand to meet an even heavier supply forecast.

In 2025, value opportunities for taxable munis were largely sector-specific and found on longer-duration positions. Healthcare and higher education are good examples, as these sectors were confronted by policy and credit pressures with attendant wider spreads relative to corporates and therefore, offering the most potential value should spreads compress, a backdrop likely to continue into 2026.

Yield advantages offered by high-yield corporates over high- yield munis within an environment of wider corporate bond spreads can be tempered by routinely stronger credit quality attributes and relatively better legal provisions that often accompany high yield municipal securities. However, while value can be found by acquiring high-yield munis, high-yield investors should exercise care when seeking alpha.

Should there be a limited supply of taxable munis, certain domestic institutional buyers of munis, such as life insurance companies, which tend to have a heavier appetite for taxable securities given their internal tax structures, may see a diluted relative value play on other taxable securities if attendant tightening of taxable muni spreads comes about. Further, should crossover buyers actively access the muni market to seek the yield advantage, ratios could be pressured lower.

Credit quality shows resilience, but greater analytical rigor is advisable

Muni credit enters 2026 from a position of strength with expectations for further resiliency even with softer growth projections and the potential for added credit pressure stemming from the One Big Beautiful Bill Act. Nevertheless, careful analysis is warranted given emerging cracks in the credit veneer.

The muni market can take comfort with the fact that there is a diversified pool of highly rated obligors across the muni landscape. Fiscal austerity should remain visible in 2026 as many municipal issuers are still carefully balancing their debt requirements against a number of other budgetary needs competing for limited resources.

While improvements are noted, unfunded pension liabilities and other post-employment benefits (OPEB) obligations may continue to be a financial drag for certain municipal budgets and the lack of stimulus funds could present budgetary challenges for certain local government obligors that currently exhibit constrained demographics and marginal reserve balances.

States possess unique credit features and budgetary tools as well as a relatively low debt burden and record rainy-day balances that make them appealing for investors at a time of expanding policy uncertainty and signs of emerging credit pressures, circumstances that are requiring the states to shoulder more of the funding burden. The uncertainty over health care subsidies and the potential for a greater shifting of Medicaid cost burdens onto the states will hopefully see clarity in 2026, and the market will be closely looking for signs of corresponding budgetary pressure.

At the state level, there are a number of individual revenue streams that do not necessarily move in unison throughout the economic cycle, with some exhibiting greater volatility than others. This could present potential budgetary challenges for state legislators and policymakers when it comes to revenue forecasting, budgetary development and identifying spending priorities. Although there is evidence of softening sales tax collections, consumers remain present against a backdrop of sticky inflation and reduced purchasing power that may have a dilutive impact upon wage growth.

I suspect that a material downgrade on a local government would reflect limited budgetary and revenue-raising capacity, a lack of economic diversification, thinning reserve levels, an increasingly challenged debt and contingency obligation position, and a management team ill-prepared to navigate its way through an economic contraction. Of note, investment-grade default experience for the local general obligation sector is among the lowest of any sector and recovery rates are typically higher.

The vast majority of cities exhibit conservative debt practices with their debt burden representing a fairly small part of overall budget, and cities are generally well-positioned to meet timely debt service payments and take on additional debt. Although cities do not show a single legal construct for the payment of debt service, most structures do prioritize debt service.

Locals typically enjoy a diversified revenue stream and have the ability to raise taxes, if necessary, with heavy reliance upon property taxes that trend stable over time after giving in to a lagging effect, yet budgetary flexibility tends to be more limited at the local level. Challenges may arise should governmental grants and intergovernmental transfers decline. Depending upon economic conditions, sales tax collections and fees from licenses and permits may be impacted.

Local credits in more problematic states could be pressured if there is a heavy reliance upon state support. I think that there are opportunities to invest in local credits from within troubled states if those credits are well-insulated from the challenges of that state's general fund budgetary process and if the local credit has either a strong GO pledge with good geographic diversification or a very secure revenue structure with ample and resilient debt service coverage, sound protective covenants, and well-defined bondholder rights and remedies. In 2026, investors should also be watching for credit stress across the K-12 and utility sectors as funding issues will likely raise concerns.

Certain revenue/enterprise credits will remain resilient. I continue to like the airport sector and when considering this area of the market, it is important to see a strong track record of maintaining ample liquidity, consistently strong margins, a clearly defined strategic mission with an ability to adapt to shifting airline routes, a manageable cost structure, and a diversified carrier and overall revenue base profile.

Credit pressure will continue to be seen within the hospital sector, despite overall credit improvement since the COVID pandemic, given the potential for governmental payor cuts, above-average margin compression given sticky health care inflation, heavier spending needs, and staffing deficiencies. Multi-state/multi-site hospitals with an extensive geographic footprint, a robust balance sheet, favorable operations, well-entrenched physician networks, an ability to adapt to shifting caseload priorities, and a clearly defined mission statement stand in a relatively better position.

Certain higher education credits will be challenged by current immigration policies, pricing pressure, shifting demographics, competitive forces and softening demand metrics. Quality-oriented investors are advised to consider those higher education credits exhibiting brand recognition, a strong and nimble balance sheet, adequate revenue diversification, manageable capital needs, and a competitive menu of academic offerings.

Evidence of relative adaptability to online/remote instruction will remain an important credit attribute. The higher education sector will likely become even more competitive and those institutions that have not differentiated themselves within an extensive field of active liberal arts schools and have limited financial resources and flexibility are most at risk of future enrollment declines and margin erosion.

Housing bond issuance could rise in 2026 with overall volume trends as the need for affordable housing becomes more of a bi-partisan talking point. State agency single- and multi-family mortgage revenue bonds offer suitable investments for quality-oriented investors given high levels of indenture reserves, cross-collateralization structures providing strong asset parity, and sophisticated financial and operational oversight.

I suspect that high-yield municipal bond defaults and impairments, especially among more highly speculative business models, such as certain types of project finance, conduit housing bonds, and lower- quality healthcare/senior living financings, could be elevated in 2026, yet I do not envision acute credit stress in the high-yield space that could materially undermine performance throughout the new year. Depending upon the economic trajectory, there could be a rise in technical defaults, with an increasing percentage of this group falling into actual monetary default with higher impairment experience.