The upcoming midterm election could significantly impact the municipal bond market, with state-level ballot initiatives on taxes and bond supply potentially playing a larger role than congressional battles. While blue states may seek to increase taxes, making muni exemptions more valuable, red states are pushing for tax breaks, which could strain local government revenues.
Experts suggest that despite increased supply, municipal bonds offer an attractive opportunity for investors, particularly those in higher tax brackets, due to strong fundamentals and high credit quality.
The upcoming midterm election is poised to send ripples across various financial sectors, with significant implications for municipal bonds. While much attention has been on the race for congressional control, what unfolds at the state level could have a more immediate and profound impact on the muni market.
Ballots nationwide feature numerous initiatives that could alter tax laws and influence the supply of new bonds. For muni investors, these changes are crucial because the income derived from municipal bonds is typically exempt from federal taxes, and often from state and local taxes if the investor resides in the issuing state.
The Diverging Paths of Red and Blue States
A clear divide exists between states based on their political leanings. Dan Close, head of municipals at Nuveen, notes a "complete bifurcation between red and blue states." Blue states, predominantly Democratic, are often seeking to implement graduated income tax structures to capture more revenue from high-income earners. This strategy can enhance the value of muni tax exemptions for investors.
For example, California is considering a "billionaire tax," which would impose a one-time 5% levy on taxpayers with at least $1 billion in assets. Another measure aims to make a temporary tax hike permanent for individuals earning over $371,000 annually, currently set to expire in 2031. Close explains that the potential passage of such tax increases would likely make the muni bond exemption more valuable, driving up bond prices as investors seek tax shelters.
Conversely, red states, typically Republican-leaning, are focusing on affordability by attempting to reduce property taxes. Florida, for instance, has a ballot measure to increase its homestead exemption for non-school district property taxes, raising it from the current $25,000 (for non-school property taxes) to $150,000 by 2027 and $250,000 by 2028 for new residents after a five-year waiting period.
Tom Kozlik, head of public policy and municipal strategy at HilltopSecurities, warns that if approved, some local governments in Florida might need to find alternative revenue sources or increase overall tax rates to offset lost income. While not necessarily leading to immediate downgrades, this necessitates careful credit research, as not all municipalities will be affected equally.
The Impact of Increased Bond Supply
Beyond tax policies, voters will also decide on approving more state or local government debt. This could add to an already robust muni market supply. According to the Securities Industry and Financial Markets Association (SIFMA), year-to-date issuance through September totaled $473.8 billion, a 7.8% increase over the same period last year. In 2025, total muni issuance hit $587.3 billion, a 14.3% jump from 2024 figures.
Cooper Howard, director of fixed income research and strategy at the Schwab Center for Financial Research, identifies supply as a primary concern stemming from the election. Sustained strong demand is necessary to keep pace with this increased issuance and maintain total returns. Fortunately, new supply typically doesn't flood the market instantly, as issuers often have a multi-year window to bring bonds to market.
The composition of the next Congress could also influence muni investors, particularly as lawmakers address fiscal and policy issues like the country's affordability crisis. Kozlik suggests that tax policy and affordability initiatives could emerge in the first quarter of next year, potentially impacting sectors such as housing, higher education, and public power financing.
Attractive Opportunities for Investors
For investors contemplating portfolio adjustments before the election, Close at Nuveen advises looking at states with potential tax increases on the ballot. Nuveen, for example, has seen significant interest in a separately managed account dedicated to Washington state, which recently enacted a 9.9% capital gains tax on income above $1 million (effective 2028), now subject to voter repeal.
Close suggests that if these tax-increasing measures are expected to pass, there could be opportunities to buy bonds in blue states ahead of the election, anticipating that bond prices will rise with increased taxes.
Howard believes munis are currently very appealing, especially for investors in tax brackets of 24% or higher. He highlights the strong fundamentals and excellent credit quality, noting that approximately 70% of the broad muni index holds a triple-A or double-A rating. Kozlik echoes this sentiment, calling yields "really attractive" and recommending investors focus on AA-rated or higher bonds for peace of mind. "The muni space is part of the portfolio that most investors want," he concludes, "It helps them sleep well at night."
