Municipal credit quality continues to be resilient. S&P reports that upgrades exceeded downgrades in most sectors in 2025, elevating average municipal ratings. Smith’s Research, which combines three rating agency actions, shows similar positive-weighted activity. However, the first quarter of 2026 saw a reversal, with downgrades exceeding upgrades by S&P. It makes sense that the ratio of upgrades to downgrades is narrowing or reversing after several years, with positive ratings actions exceeding negative actions. We have wondered for years when the credit outlook might change, since it has been strong for so long, even with challenges.
Munis have an average rating of AA, reflecting strong economies, improved budgeting tools, and financial cushions to help manage challenges that may lie ahead. Challenges include the ending of pandemic stimulus (some aid still flowed in 2026) that helped many municipalities over the hump of Covid-19 restrictions, changes to federal funding such as FEMA and Medicaid that need to be managed, as well as effects of the Iran war such as increasing oil prices and inflation and cyber risks.
Munis should prevail and usually do. The default rate is practically nonexistent for safe-sector, highly rated bonds. The default rate is extremely low and concentrated on non-rated or lower-rated bonds. The average five-year cumulative default rate from 2015 through 2024 for investment-grade munis was a very low 0.04%, according to Moody’s, which is multiples lower than the 0.85% for investment-grade corporates. States have oversight and monitor local governments, which can act as an early-warning system to identify problems and trigger actions to provide aid in management or finances. Fortunately, states have many revenue sources, the ability to adjust expenses and revenue, and healthy reserve positions.
Effect of War
The Iran War is affecting oil prices and inflation expectations, supply chains – which we have some experience with since the pandemic – and increasing fear of and potential for cyber-attacks, including on water and electric infrastructure, much of which is managed by municipalities. All these raise costs for munis and their residents and challenge their management. Oil price increases and volatility ripple through the economy, as the cost and availability of many items rises and there is reduced disposable income to purchase other items, bringing increased concerns of affordability. Supply chains can alter and reduce the flow of goods, affecting ports and other modes of transportation as well as raising prices. Analysts and rating agencies already evaluate cyber risk and the sophistication of munis in managing it. Reductions in the Department of Homeland Security may reduce technical assistance the federal government can provide to munis. Increased cyber risk from war or other sources of hacking raises the cost of combating attacks as well as the cost of cyber insurance. On an ironically bright side, higher prices yield higher sales tax revenue to many munis.
FEMA funding changes would affect some states more than others
Last year, Municipal Market Analytics (MMA) conducted a study comparing disaster aid received to state GDP. In 35 states, including CA and NY, the aggregate amount of FEMA aid obligated from 2015–25 amounted to less than 0.25% of the respective state’s 2024 GDP. In 43 states, had affected munis raised those funds in the bond market, aggregate new-money issuance in that period would have had to increase by less than 5%. This implies that a world without FEMA-style federal aid would have posed only modest long-term risk to state and local ratings, credit spreads, and investor performance.
For the states that are more exposed to disasters – Louisiana, Hawaii, and Florida and to a lesser extent North Carolina, West Virginia, and Vermont – aggregate FEMA aid ranged from 4% of state GDP to half a percent. If debt had been issued to replace FEMA aid, MMA analysis suggests that bonded debt would be much higher and ratings could be a notch or two lower.
We have seen extreme weather events hit states that were not typically prone to them. These states are less prepared for disasters and may need more help to manage through.
The future of FEMA aid is still being discussed, and the outcome could be less drastic than full elimination. It does appear there will be more direct state involvement and that the focus will be on resiliency and away from rebuilding the same failed infrastructure in the same locations.
Disaster Recovery, Rebuilding, and Resilience Conference
I am a member of the board of the Southern Municipal Finance Authority (SMFS), a local society of the National Federation of Municipal Analysts (NFMA.org). We will be hosting a conference in Asheville NC, which suffered extreme flooding in 2024 in the wake of Hurricane Helene.
We’re bringing together state and local governments, industry experts, finance professionals, and community partners to explore how municipalities can rebuild stronger, smarter, and more equitably in advance of and after natural disasters: Disaster Recovery, Rebuilding, and Resilience Conference. It’s a beautiful time of the year in Asheville, we invite you to look into joining us.
Federal changes and anti-fraud measures
Most agree that greater oversight of programs to combat fraud and improper grant payments should improve governance and expense controls as corrective actions are implemented. However, task force actions may cause delays or reductions in funding or potential penalties, yet another credit challenge for state and local government budgets over the next year or so.
Extreme weather
The funding for disasters aside, the frequency and intensity of weather events from droughts and wildfires to hurricanes and extreme flooding can make a state less desirable to live in. Changing weather has produced wildfires, drought conditions, and extreme rainfall leading to water supply problems that can constrain growth. The fear of damage and disruption, higher insurance costs and higher utility rates are considerations. Further exacerbating water and electricity issues are data centers, which have extremely large utility needs for processing and cooling. Data centers sometimes receive tax incentives to locate to an area, helping the muni local government but not necessarily the utility ratepayers.
Demographics, population movement, and growth
Warmer-weather states and lower tax rates have long been a draw for retirees; but as noted above, extreme weather and increased costs may be changing that dynamic. The aging of the population and lower birth rates affect the credit quality of higher education and K-12 institutions as enrollment in many areas declines. The growth of charter schools has also challenged the education sector. We have seen the movement from high-tax to low-tax states by individuals as well as businesses; and many lower-cost, middle-of-the-country areas are making their communities more livable and retaining younger folks and retirees who may have thought about moving. How these longer-term trends evolve and how munis manage these changes are slower-moving determinants of credit quality and bear watching.
State tax increases and decreases
States compete in many areas, and tax rates are part of the competition. Wealthy, high-tax jurisdictions are doubling down and looking to increase income taxes. They include NYC and CA, to name a few. Washington State, which does not have an income tax, is instituting a 9.9% tax on incomes over $1 million. This tax is not effective until 2029, so residents have time to prepare or to move. This contrasts with states reducing tax rates to become more competitive, such as Mississippi and Alabama. Then there are states looking to reduce or eliminate property taxes, such as Florida. Property taxes are viewed as a very strong security for the backing of general obligation bonds, and they will remain a source of municipal funding. However, the growth in property taxes in some areas is concerning to residents, and the emphasis on limiting revenue sources will focus management on expenses, efficiencies, and rationalization of services.
NYC rating outlooks revised to negative
In mid-March, Moody’s, Fitch, and Kroll rating agencies changed the outlook for NYC AA-rated GO bonds to negative from stable, based on the mayor’s preliminary budget, which reflects larger than previously reported and widening out-year budget gaps, even with the use of some reserves. Uncertain gap-closing solutions that could require city or state approvals, such as income and property tax increases, are included in the budget or budget discussions. On the positive side, all the rating agencies acknowledge New York City's still-favorable economic conditions.
S&P notes the preliminary budget is unbalanced and includes uncertain revenue assumptions; however, it maintained a stable outlook on the city’s bonds. The stable outlook focuses on the framework and the well-established multifaceted budget development process that generally works to arrive at a balanced budget and a surplus at the end of the fiscal year. S&P expects proposals and negotiations will likely evolve over the coming months – as will the outlook on the city’s bonds.
In November we noted the strong budget framework of New York City that was instituted after the fiscal crisis of 1975 and challenges that the city may face. “NYC Mayoral Election 2025.”
Speaking of NYC – Congestion pricing and MTA
MTA has many funding sources, including proceeds from various state- and city-related bond issues, grants, and subsidies. MTA issues transportation revenue bonds backed by gross revenue, including excess bridge and tunnel tolls. The bonds are rated in the A category. The scale of the system and debt issued makes new revenue sources, like congestion pricing, important for supporting MTA’s capital program and long-term credit quality. The fee charged for traffic traveling below 60th Street during most hours of the day is very high and contested. London was the first large city to institute congestion pricing, and it is successful or at least tolerated there. Much of MTA’s funding comes from tolls collected on the bridges and tunnels entering NYC, whose traffic the congestion pricing has reduced. However, the mass transit system of subways, buses, and trains is the spine of the economic engine of New York City and surrounding areas. The city’s importance to the state is shown by recent state funding increases.
Although controversial, New York’s congestion pricing program has enjoyed strong initial success, generating about $548 million in its first year – exceeding expectations – while reducing vehicle entries into Manhattan’s congestion zone by roughly 12% and contributing to increased transit ridership. This adds diversity of revenue and could add to credit quality. The mechanism, however, needs to survive legal, political, and economic risks. The charge is unpopular and may reduce revenue from bridge traffic.
Pensions
Improving pension funding has been the focus of municipalities, their pensioners, taxpayers, and muni analysts for years now, especially after recognition that underfunding a plan can be more expensive than making regular periodic payments so that the funded level grows and does not decline. The implementation in 2012 of the Government Accounting Standards Board (GASB) pension reporting rules, in part to better inform constituents after the 2007–08 financial crisis, required improved reporting of pension funded status and assumptions used. In times of economic stress, however, not fully funding annual payments to a pension fund may be a tempting way to reduce expenses; and as we enter more uncertain times, pension funding will continue to be evaluated. The trend of fewer workers supporting an expanding number of retirees adds to the importance of discipline in pension funding.
State and large-city pension funding levels have improved. According to an S&P January 2026 report, US public pension funded ratios reached an average of 80% as of the close of fiscal 2025. Pew Charitable Trust also notes improvements in funded levels.
Private assets, which are generally less transparent and less liquid than publicly traded assets, have increased as pension investments. S&P, using data from Cliffwater.com estimates that private debt and private equity have increased to 19% of state plans while data from the Public Plans database shows increases to private equity for local plans, too. Long-term liabilities like pensions do generally invest in longer-term, higher-yielding investments to combat inflation and to meet future pension payments; however, careful selection is important. Calls for more transparency of private assets are being heard.
State rating changes
Mississippi’s S&P AA rating outlook was changed to stable from negative in mid-March, while Moody’s rates the debt Aa2. The outlook improvement is due to the state’s ongoing commitment to structural budget balance and maintenance of healthy reserves, despite modest revenue declines from recent tax reductions and generally slower economic growth compared with that of the US as a whole. It also reflects pension plan changes that should help improve funding progress in the medium to long term.
On 1/9/2026 New Mexico was upgraded by Moody’s to Aa1 from Aa2, while S&P rates it AA stable. The action is driven by the state's well-established and prudent governance practices that have partially mitigated its reliance on volatile severance taxes. Investment earnings from more substantial permanent fund balances are now a more significant revenue source. There is some negative credit exposure from federal policy priorities that have led to federal job losses and the loss of Medicaid eligibility for approximately 100,000 residents beginning in January 2027. Overall employment growth continues, driven by job gains in other sectors, including state and local government and education.
Conclusion
There are over 50,000 municipalities in the United States, and each of them can issue many different types of debt. General obligation bonds fund school districts and local government improvements to buildings and roads. Munis can issue sales tax-backed bonds for transportation and downtown development, or utility rates and fee-backed bonds for water, sewer, and electric projects. Then there are the not-for-profit entities that issue muni bonds, such as in the healthcare and higher education sectors. And the list goes on. The muni market is about $4 trillion and is overseen by municipal management, elected officials, residents, federal and state governments, rating agencies, and investors. It is an important aspect of funding the infrastructure of this country, in contrast to practices in more centrally planned or bank-financed countries. Legal structures and security provisions in bond documents provide protection to bondholders and allow munis to continue to access the capital markets at lower-cost tax-exempt rates to fund services. This is important, as muni bond issuance is expected to increase again this year to $600 billion from $580 billion in 2025 and from an average of $400-$450 billion over the last decade.
There are many challenges ahead for munis. Some are long-tailed and some are more immediate. If the economy turns to recession, which is not anticipated at this time, these challenges will be accentuated and we would expect more downgrades, depending on methods management uses to address the challenges. Strong reserve and rainy-day fund balances, improved budget management, well-funded pensions, and a generally growing economy all bode well for the future of muni credit quality.
Patricia Healy, CFA
SVP, Research
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