Muni credit solid as federal surplus shifts to shortage

For state and local governments, federal funding in the 2020s has been a case of “what goes up must come down.”

In 2020 and 2021, the federal government disbursed nearly $1.2 trillion in aid to counter the shock and aftermath of the pandemic. More than half went to state and local governments, but most of that money has been spent. It would be one thing if they had to return to operating under their traditional levels of income. But bent on reducing expenses, the Trump administration has started to cut funding that the federal government has been sending to states and local entities. In most cases this amounts to the second-largest source of subsidies for their budgets.

Investors would be right to worry about the impact on municipal credit, especially with the possibility that a trade war could spark a recession. But most municipal issuers are in a strong position to face these challenges because they shepherded the stimulus payments and because the situation is ripe for increasing taxes. In fact, since the pandemic, municipal credit quality has generally improved. During every quarter from 2021 through the end of 2024, Moody’s rating upgrades have exceeded downgrades by a ratio of 2.8 to 1.

The federal support during the pandemic served as a lifeline at a time when stores were shuttered and residents unable to work. The Pew Trusts note that prior to the pandemic, federal aid accounted for about 32% of state budgets. This figure rose to about 36% as the aid was distributed. But many treasurers and managers shrewdly used much of the money to bolster balance sheets, address underfunded pensions and tend to other financial issues. Illinois is a prime example. In 2020, it carried the lowest investment-grade rating at each of the three major ratings agencies, but through good management, it has seen several upgrades. It now carries ratings of A-/A3/A-.

But if federal funding does decline, state and local governments likely can pick up the slack via taxes, their largest source of funding. While raising taxes will undoubtably face some political headwinds, many municipalities can simply return previous decreases in the tax code to their levels before the pandemic to cover the federal shortfall: From 2020 and 2024, 22 states cut personal income tax rates, 14 lowered corporate income tax and four cut their sales tax. In total, 27 states decreased at least one of these sources—and several states cut more.

Local governments also rely heavily on property taxes and have benefitted from a huge increase in home values. The S&P CoreLogic Case-Shiller 10-City Index has risen an astonishing 54% since the beginning of 2020. Although commercial property valuation has struggled of late—the Real Capital Analytics Commercial Property Price Index has fallen 12% from its peak in 2020—it is still up 12% from the beginning of 2022.

Most sectors are in good shape

Issuance is the other major source of capital, and investors should be comforted that credit quality is high and that many security sectors are quite resilient. The foremost are General Obligation bonds, which represent about one-third of issuance, as they reflect the largely solid financial picture of most municipalities. Other sectors in a good place include essential utilities, such as Public Power, and Water & Sewer.

Two sectors, however, seem particularly vulnerable: Hospitals and Higher Education. Hospitals have struggled with higher costs and worker shortages since the pandemic, and they now face the prospect of cuts to Medicaid. With their balance sheets already weakened, additional revenue cuts would undermine their credit quality. Higher Education is facing demographic changes, the prospects of an endowment tax, cuts to student aid and a challenging political atmosphere. These two sectors are among the few where downgrades have outpaced upgrades over the past few years.

Residents love to debate how their local governments, municipalities and other entities use tax revenue and federal funding, but they are generally in a strong position to deal with hard times. By building up reserves and dealing with expenses, most have a cushion that will soften the blow as political gravity pulls federal funding back to earth.