Municipal bond yields: A renaissance of tax-exempt income

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Municipal bond yields: A renaissance of tax-exempt income

Vanguard Perspective


August 18, 2022

Key highlights

  • Municipal bonds now feature much improved yields (especially after adjusting for taxes) because of the negative returns they experienced in the first quarter of 2022.
  • These higher yields are available even as creditworthiness for municipal issuers is arguably stronger than it has been in recent years.
  • The risk of price volatility persists, but a cost-averaging buying strategy can help to mitigate this risk.

What goes down must go up

Municipal bonds suffered a 6.58% loss from December 31, 2021, through July 31 of this year,1 drawing the notice of investors accustomed to a low-volatility tax-exempt bond environment.

But in fixed income, what goes down in price must go up in yield. Nominal municipal bonds featured a yield to maturity of 2.79% as of July 31.1 That presented attractive valuations both relative to other bond sectors and from a historical perspective. In the past ten years, muni yields have only been higher 13% of the time within daily observations. With a AAA Muni yield/Treasury ratio of 97% at 30 years, tax-exempt debt is particularly attractive in the long end of the yield curve.

Depending on an investor's state and federal income tax brackets and the particular investment, the investor's tax-equivalent municipal yield may be higher than 5%. For investors in higher-tax states like California and New York, taxable-equivalent yields of corresponding state indexes may be nearly 5.75% for CA, or higher for NY.

Municipal tax-equivalent yields are relatively attractive

(as of July 31, 2022)

Bar chart that shows the tax-equivalent yield in municipal bonds, which translated to the yield for an investor in the highest federal income tax bracket facing a Medicare income tax surcharge, was 4.71% as of July 31, 2022. That was higher than the yield of the next highest category, U.S. corporates, at 4.33%.

Source: Bloomberg indexes, using yield-to-worst data as of July 31, 2022. The municipal tax-equivalent yield is calculated using a 40.8% tax bracket, which includes a 37.0% top federal marginal income tax rate and a 3.8% Net Investment Income Tax to fund Medicare.

Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.


Despite the negative returns it took to get here, higher municipal yields potentially can provide higher levels of tax-exempt income for years to come.

How the market turned

The municipal market, despite its idiosyncratic nature, is much influenced by U.S. Treasury yields. When Federal Reserve officials signaled their commitment to fighting inflation early this year, investors began pricing in some 11 to 13 quarter-point expected interest rate hikes through 2022, which upended the fixed income markets. Municipals were no exception.

A fundamentally solid market

Typically, a significant risk-off event is required to reach current yield levels, such as an economic recession. Such conditions threaten downgrades or even defaults. But in today's environment, municipal credit has been bolstered by federal fiscal stimulus provided directly both to municipalities as well as to end consumers.

State and local income tax revenues have risen at a velocity not seen in 20 years, easing near-term credit concerns. Issuers have used some of the flood of finances to build up their rainy-day funds, which can be a cushion for meeting budgets even during recessionary or otherwise difficult conditions. All of which means that credit conditions are better than they have been in years. Such measures will likely safeguard municipal bond valuations relative to other credit sectors (like U.S. corporates) in the event of a downturn.

States' rainy-day funds as a percentage of general fund expenditures

(50-state median, for fiscal years indicated)

Bar chart that shows states’ funds set aside for recessionary times or emergencies, called rainy-day funds, have increased in recent years as a percentage of general fund budgets. The 50-state median was 8.4% in fiscal 2020 and an estimated 8.1% in fiscal 2021

Sources: Pew Charitable Trusts, using data from the National Association of State Budget Officers as of December 31, 2021.

National totals for state and local income taxes

(in billions)

This line graph shows total state and local income tax collections in the United States from 1999 through 2021. The graph clearly shows an acceleration of income tax receipts for issuers of municipal bonds starting in 2020, nearing $650 billion for 2022. Source: U.S. Bureau of Economic Analysis, as of June 30, 2022." Name: "This line graph shows total state and local income tax collections in the United States from 1999 through 2021. The graph clearly shows an acceleration of income tax receipts for issuers of municipal bonds starting in 2020, nearing $650 billion for 2022. Source: U.S. Bureau of Economic Analysis, as of June 30, 2022." aria-labelledby: Not specified aria-label: Not specified alt: "This line graph shows total state and local income tax collections in the United States from 1999 through 2021. The graph clearly shows an acceleration of income tax receipts for issuers of municipal bonds starting in 2020, nearing $650 billion for 2022. Source: U.S. Bureau of Economic Analysis, as of June 30, 2022.

Source: U.S. Bureau of Economic Analysis, as of June 30, 2022.


Cost averaging in reentry

These arguments for an attractive yield in a healthy market are not meant as a timing signal, since there are risks with all investments.

It is possible that the market will continue to price in more interest rate hikes and that outflows could continue. Either of these potential events could lead to further price drops (and yield increases) in the near future.

However, the bond market has already factored in an aggressive Fed rate-hiking campaign. While there is substantial uncertainty around Fed policy in 2023, longer term yields seem to be settling close to the Federal Reserve's long-run neutral rate of 2.5%. If markets calm around these levels, it could create a technical tailwind for municipal bond pricing as cash that left tax-exempt funds earlier in 2022 may return.

Investors considering a new allocation to the muni sector, or those hoping for reentry after fleeing earlier this year, might consider a cost-averaging strategy. This would help diversify the risk of coming in too early or too late.

A better buffer

With yields as high as they are, municipal bond funds offer a buffer against yields rising even further. A muni bond fund with a yield of 2.79% and a duration of 6 years, would still provide a positive return for the next 12 months even if yields were to rise another 40 basis points across the curve.

Duration is the weighted average time for an investor to receive coupon interest and principal payments that would potentially allow the investor to recoup the bond's price from its cash flows.

Vanguard municipal bond funds

Admiral™ or ETF Shares

Expense ratio2


Tax-Exempt Bond ETF



Short-Term Tax-Exempt



Limited-Term Tax-Exempt



Intermediate-Term Tax-Exempt



Long-Term Tax-Exempt



High-Yield Tax-Exempt





California Intermediate-Term Tax-Exempt



California Long-Term Tax-Exempt



Massachusetts Tax-Exempt3



New Jersey Long-Term Tax-Exempt



New York Long-Term Tax-Exempt



Ohio Long-Term Tax-Exempt3



Pennsylvania Long-Term Tax-Exempt



1 Figures as indicated by the Bloomberg Municipal Bond Index.

2 As reported in each fund’s most recent prospectus. A fund's current expense ratio may be higher or lower than the figure shown.

3 Investor Shares available only. There is no minimum investment required for advised clients.



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  • Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
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