• Municipal bond yields mostly followed the trend of Treasuries during the first quarter, easing across the curve early in the year before rising sharply upon the outbreak of war with Iran, which caused longer-term yields to increase more than short-term yields.
• The market’s ability to absorb another quarter of record new issuance was impressive in the face of supportive fundamentals.
• Signs of the war’s energy supply shock and financial toll have started to trickle into the macroeconomic data, and we believe some level of inflationary pressure is likely to persist even if this conflict ends sooner.
• In the face of uncertainty introduced by the war and challenges facing policymakers, we believe research-driven underwriting can help uncover opportunities in out-of-favor areas with wide dispersions in yields.

When all was said and done, the strength of January and February was pretty much undone by March’s weakness, and muni index returns ended the first quarter wrapped around zero. The S&P Municipal Bond High Yield Index gained 0.3%, while both the S&P Municipal Yield Index, which includes bonds across the quality spectrum, and the S&P Short Duration Municipal Yield Index lost 0.2%. For comparison, the Bloomberg US Aggregate Bond Index was flat during the period.¹

Municipal issuance set another new record with $119 billion in tax-exempt bonds and $128 billion in overall issuance.¹ In the face of complicated and rapidly evolving dynamics that included the outbreak of war, spiking energy prices, renewed inflation concerns, whipsawing policy expectations and acute Treasury volatility, the Municipal Credit team was impressed by the municipal market’s ability to absorb significant issuance; in our view, it is a testament to steady investor interest in the asset class and the appealing yields on offer.

Muni Market Resilient Amid Volatile Conditions

Given the quarter’s complicated and rapidly evolving dynamics—including the outbreak of war, spiking energy prices, renewed inflation concerns, whipsawing policy expectations and acute Treasury volatility—the municipal market’s ability to absorb $119 billion of tax-exempt new issuance (and $128 billion overall) was impressive, in our view, and is a testament to steady investor interest in the asset class and the appealing yields on offer. Tax-exempt new issuance was 13% higher than in the first quarter of 2025, a year that ended up setting a new annual record. As it had been throughout 2025, issuance was predominantly new capital, with less than one-quarter going toward refunding activity.²

Municipal bond yields mostly followed the trend of Treasuries during the first quarter, easing across the curve early in the year before rising sharply in March as a shock to the global energy supply chain, brought on by the war with Iran sent energy prices sharply higher and raised concerns about renewed inflation. The end result was a bear steepening in which longer-term yields increased more than short-term yields.

Market-indicated federal funds rate expectations have been volatile; while two cuts had been priced in prior to the war, by late March markets were expecting a rate hike, and markets are now more or less flattish. The Fed, in contrast, has been more measured in its response to the ramifications of the war, leaving its policy rate unchanged in its mid-March meeting and continuing to project one rate cut before year end; this caution likely reflects the common practice among central bankers to “look through” energy shocks. That said, Fed board members’ median expectation for 2026 core personal consumption expenditures (PCE) inflation increased to 2.7%, from 2.4% previously, and the notably wide distribution of inflation forecasts—from 2.3% to 3.4%—highlights the uncertainty introduced by the war and the challenges facing policymakers.⁴ With some level of inflationary pressure likely to persist even if the war ended today, Fed rate cuts would seem to be a challenge absent much tighter financial conditions or substantial labor market deterioration.

Meanwhile, signs of the war’s financial toll have started to trickle into the macroeconomic data, providing some insight of what may lie ahead. The US headline consumer price index for March increased 3.3%, its highest level in nearly two years, driven by skyrocketing gasoline (up 18.9%) and fuel oil (up 44.2%) prices. Though food prices increased a more modest 2.7%, the energy shock is likely to further pressure a US agriculture sector already struggling with the impacts of trade and immigration policy, which may ultimately contribute to higher food prices.⁵

We have yet to see a GDP print for a period encompassing the war—the Bureau of Economic Analysis will release its initial first quarter estimate on April 30—but the latest GDPNow forecast expects growth of 1.3% compared to estimates of around 3% in February.⁶ This would come on the back of a disappointing 0.5% reading for fourth quarter 2025, down sharply from the third quarter’s 4.4% growth due in part to the 43-day government shutdown.⁷

Steady Fundamentals Persist

Issuer fundamentals continue to be supportive, even as they normalize from the stimulus-fueled conditions of the pandemic years. Overall state budgets for fiscal 2026 reflect a healthy environment, and general fund balances remain well above the historical average. Though state general fund revenue has fallen off the record pace of fiscal 2021 and 2022, it has continued to grow, and modest revenue gains are expected in fiscal 2026. Budgets enacted to date suggest flat general fund spending in 2026, and most states plan to maintain or increase the size of their rainy-day funds—many of which are already at nominal highs—in anticipation of future needs.⁸

These dynamics have supported muni bond ratings activity, which has remained positive even as the ratio of upgrades to downgrades continued to moderate: positive activity (including both upgrades and favorable outlook revisions) outpaced negative activity at a rate of 1.3x in the first two months of the year, down from 1.9x in 2025.¹⁰ Both defaults and first-time distressed debt remained very low in the first quarter.¹¹