Executive Summary
This week brought a confluence of developments that, taken together, strengthen the case for tax-exempt municipal bonds. Democratic-led states are advancing new taxes on high earners — a dynamic that historically increases demand for tax-free income. At the same time, a recent sell-off has cheapened the muni market, creating what we view as an attractive entry point. Federal Reserve leadership is in flux, and near-term rate policy remains on hold amid renewed inflation concerns tied to the Iran conflict. Our view: for tax-sensitive investors, the setup for munis is as constructive as it has been in some time.
What Happened This Week
Blue States Push Taxes on the Wealthy
Washington State enacted its first income tax in nearly a century, levied on millionaires. Maine passed a 2% surcharge on income above $1 million — expected to affect roughly 2,600 filers. Minnesota progressives have floated a tax on residents with net worth above $10 million, though that proposal faces a tougher path through the legislature. The direction of travel is clear: taxing high earners is, as one strategist put it, politically saleable, and the trend is gaining momentum across Democratic-led states.
Munis Got Cheap in March — and a Major Manager Is Buying
Municipal bonds fell 2.3% in March, their worst monthly showing since 2023 and a sharper decline than Treasuries experienced. The sell-off was driven largely by the Middle East conflict, which pushed oil prices higher and reignited inflation concerns. David Hammer, who heads muni portfolio management at PIMCO, is calling the current pricing a buying opportunity. We agree with the framing — munis now offer better relative value than they have in months.
Fed Policy: Patience on Rate Cuts
Fed Governor Christopher Waller said he is cautious about cutting rates in the near term, citing the energy shock from the Iran conflict and the risk of a prolonged inflation impact. New York Fed President John Williams echoed the restraint, saying high uncertainty argues against strong forward guidance — though he still expects rate cuts over the longer term once inflation eases. Separately, Goldman Sachs CEO David Solomon noted that recession risk could shift quickly depending on administration posture, though baseline forecasts for a downturn remain relatively low.
Leadership Change at the Fed
Kevin Warsh, President Trump’s pick to lead the Federal Reserve, testifies before the Senate Banking Committee next Tuesday. Warsh has long argued the Fed needs what he calls regime change. His confirmation hearing will be our first real window into how he plans to reshape monetary policy — and markets will be watching closely for signals on rate path, balance sheet policy, and the Fed’s framework more broadly.
Our Take
The bullish thesis on municipals strengthened meaningfully this week. Three forces are converging:
- Rising marginal tax rates at the state level. When top earners face higher state income taxes, the after-tax yield advantage of munis expands. Washington and Maine just made that math more favorable. Even if Minnesota’s proposal stalls, the political direction is clear, and more states will likely follow.
- Attractive entry levels after the March drawdown. The 2.3% decline pushed muni/Treasury ratios meaningfully wider. That cheapening creates opportunity for investors with cash to deploy — and it’s the reason managers like PIMCO are publicly stepping up.
- A Fed on hold, not hiking. The inflation scare from the Iran conflict has pushed rate cuts further out, but the Fed is not signaling additional tightening. That’s a stable backdrop for fixed income — and it lets investors earn coupon while waiting for the eventual easing cycle.
The principal risks to this view are a renewed inflation shock from energy markets, a meaningful policy pivot at Warsh’s Fed, or a supply surge in the muni primary market. None of these appears to be the base case, but all warrant monitoring.
Recommendations
Put Cash to Work in High-Grade Munis
For clients sitting in money market funds or short Treasuries, we recommend redeploying a portion into investment-grade tax-exempt bonds. The March cheapening has improved entry levels, and the macro setup — higher state taxes on the wealthy, a patient Fed, no imminent recession — supports the asset class. We favor AA and AAA general obligation and essential-service revenue credits – while trying to buy insured paper along the way.
Extend Duration Selectively
With the Fed on hold and rate cuts pushed out but still expected, we see value in extending from the front end toward the intermediate to the longer end of the curve, while locking in yields. Stay mindful of the call dates, 3–5-year calls are preferred. Clients with existing short ladders should consider lengthening on new purchases – happy to have these discussions with you.
Prioritize High-Tax States
For residents of high-tax states — California, New York, New Jersey, and increasingly Washington and Maine — in-state munis offer compounded tax benefits. The after-tax yield pickup from double-exempt bonds has widened alongside the policy shifts discussed above. For Texas-based clients, the calculus is different: focus on credit quality and yield rather than state-level tax optimization. We continue to focus on well ran states with solid budget fundamentals, should you have questions on your positions or how the state is ran, let us know.
Hold Quality; Be Selective on High-Yield Munis
We are not recommending a broad move into high-yield municipals as this is not where we focus. With that said, credit spreads in the lower-rated segment have not widened meaningfully alongside the rate-driven sell-off, meaning investors are not being compensated for taking on credit risk. We would continue to focus as indicated above on AA to AAA rated securities.
Let’s Talk
If you would like to discuss how these developments apply to your specific portfolio, tax situation, or cash position, please reach out. We are actively reviewing client allocations in light of the current setup and welcome the conversation.
