Many things remain up in the air and new challenges have arisen! Last quarter we noted so many changes, but all at the same time is unusual. See “Q1 2025 Credit Commentary Trump 2.0 Effect on Munis and Other Challenges.” Tariff negotiations have yet to be finalized, and the August 1st deadline may see some tariffs revert to 50% if deals are not completed or the deadline isn’t extended again. Federal funding of many institutions and programs is changing and being challenged in the courts and social media. Funding to states for Medicaid, education, and other items is finalized with passage of the Big Beautiful Bill, and now affected parties can finalize or adjust budgeting. And the rise in global tensions has brought more uncertainty. However, the US economy and markets seem to be taking the change and uncertainty in stride.
Importantly, tax-exemption of munis was preserved with the passing of the federal budget. It has often been viewed by some politicians as a revenue raiser; however it has bipartisan support because munis fund much infrastructure in our country at a lower cost than if munis were taxable. The increase in muni debt issuance has been just for that reason, as well as to reduce the use of reserves for capital improvements as we head into uncertain times as the effect of tariffs and federal policy are addressed. The larger supply and perception of credit concerns have raised yields on munis, especially in the longer end. Ratios are compelling, at 93% of the 30-year Treasury to a yield of 4.54% on July 1, which translates to better taxable equivalent yields depending on an individual’s tax rate. We expect this to increase demand for munis. See “A Forward-Looking Perspective on Municipal Bonds.”
State budgets are contending with federal funding changes and lower projected revenue from lowered tax rates or economic weakness. However, most states remain in a strong reserve position. S&P estimates based on states’ 2026 budgeted reserve positions indicate that 47 states are able to withstand a 5% decline in revenue and 34 can withstand more than a 10% decline. On average, the revenue decline was about 6% during the 2019–2020 pandemic. California, Washington, and Illinois are states that have less than 5% reserves projected for the end of fiscal 2026. In the state rating actions section of our commentary we highlight the three states that changed during the quarter: Maryland was downgraded and Arkansas and Alaska were upgraded.
Hurricane season started June 1, and a record number of storms has been projected, highlighting the need for resiliency of municipalities. Natural disasters from extreme climate events are expected to continue with longer-lingering storms. The disaster in Kerr County, Texas, with the super-fast rise of the Guadalupe River causing loss of lives, further stresses this point. Our hearts and prayers go out to all those affected by the devastation. The governor called for a state of emergency, and it was approved by the president. This opens the door for FEMA funding. The devolving of more responsibility and funding to the states is underway, and this year’s federal and state reactions to disasters will be watched carefully.
The US Lost its Moody’s Aaa Rating
In some respects, the downgrade was a nonevent, because the US had already lost its S&P (2011) and Fitch (2023) AAA ratings. The Moody’s rating change, which was primarily based on the failure of consecutive administrations and Congresses to rein in the deficit, came at a time when there are expectations that the federal deficit and the interest expense to service the debt are not going to be reduced any time soon.
The downgrade did have a ripple effect through the bond markets, in the form of downgraded credits that depend on government support, assume a certain level of government support, or are supported by other federal government securities that also lost the Aaa rating. See “Moody’s Downgrade of the US to Aa1 and the Ripple Effect on Bond Ratings.”
Moody’s revised the outlook on the US to stable from negative. Moody’s emphasized in their opinion the resilient nature of the United States, with its exceptional economic strength, high-quality institutions, and governance strength, as well as its extraordinary funding capacity, supported by the unique and central roles of the US dollar and Treasury bond market in the global financial system.
Sector Outlook Changes – Negative and Related to Tariff Uncertainty
Moody’s revised its outlook on airports to negative from stable. It expects enplanements to decline modestly in 2025 versus last year because of a deceleration in economic growth. They further noted that tariffs and trade tensions will curtail leisure and business travel, while consumer confidence has waned. Airlines will hasten efforts to reduce capacity growth because of lower demand in the domestic leisure market. Moody’s does not expect enplanement losses to be as severe as in past economic downturns. Transportation Security Administration daily screenings have been mostly flat so far in 2025.
Moody’s revised its outlook on ports to negative in April, noting that tariffs and policy uncertainty will dent trade volumes and reduce business and consumer confidence. Some ports will be more affected than others. The West Coast ports that receive traffic from China are expected to be most affected.
Moody’s changed its outlook on not-for-profit institutions such as museums, research institutes, and philanthropic foundations, among others. Federal policy changes and more cautious consumers are creating revenue uncertainty. Ongoing investment volatility continues to threaten liquidity, balance sheet strength, and fundraising prospects. And the potential impact of increased tariffs increases risks related to interest rates, capital spending, and the pace of economic growth. Many of the not-for-profit institutions that Cumberland invests in are highly rated and well regarded.
Fitch Ratings revised its outlook for the water and sewer sector to deteriorating from neutral. This change is largely due to a higher effective tariff rate affecting the sector and rising inflationary pressures. The US water and sewer sector is capital intensive and often relies on materials and equipment from international suppliers, which is driving up costs. S&P has had a negative outlook on the sector due to aging infrastructure and increased regulation.
Although there are a number of negative outlooks on sectors, overall, ratings upgrades have still surpassed downgrades. The challenges ahead and lower revenue projections may mean this trend changes. Higher ed continues to be challenged by aging demographics and the expected decline in foreign students, increasing endowment taxes, and reduced federal funding of research, all of which needs to be addressed in budgeting. Harvard continues to be in the news as many of its funding sources have been discontinued for now and the illiquidity of its investment in private equity is being evaluated by the SEC. Public college and university systems are not immune to changing demographics. Penn State reported it is closing seven smaller campuses over a two-year period due to declining enrollment and financials. However, it plans to invest in the 13 remaining schools. In some cases, schools that are closing in PA and other states may have been economic engines for their communities, and local ratings could be affected.
Healthcare also remains under pressure, given Medicaid reductions and changing reimbursement schemes. Especially, rural hospitals will feel pressure. States help fund Medicaid, so what happens at the state level will trickle down to the local level. States can choose to reduce reserves to help locals or could continue budgeted levels of funding, putting pressure on local municipalities and agencies. Oftentimes states do help local entities with funding or other assistance to reduce stress.
State Rating Changes
Maryland lost its Moody’s Aaa rating
The downgrade was driven by economic and financial underperformance compared to Aaa-rated states, which is expected to continue given the state's heightened vulnerability to shifting federal policies and employment uncertainty, and its elevated fixed costs. The downgrade affects outstanding debt, with aggregate par value of about $15 billion. The outlook on the issuer and long-term ratings has been revised to stable from negative.
Arkansas upgraded by S&P to AA+ stable
The upgrade reflects Arkansas' active budget management and expenditure controls, which have enabled the state to maintain financial stability through various economic cycles, and which have also yielded steady operating surpluses and growth in reserves and liquidity to levels near historical highs during a recent period of positive economic momentum. The rating agency also noted the state’s commitment to maintaining budget balance. The outlook is stable.
Alaska upgraded by Moody’s to Aa2 with a stable outlook
The upgrade reflects the legislature's record of restraint on appropriating citizen dividends from the Alaska Permanent Fund's Earnings Reserve Account. This restraint allowed the state to rebuild its rainy-day fund to $2.9 billion in April 2025, from $914.5 million at the end of fiscal 2022. The stable outlook is supported by strong budgetary reserves and Alaska's ability to offset future oil revenue volatility by making sustainable draws from the Permanent Fund.
Second Half 2025 Credit Outlook
In the second half of 2025 we expect to see continued budgetary discipline by municipalities; however, we expect some reductions in the reserves that have been built up over the past few years. Reserves and/or rainy-day funds are held to provide flexibility for unseen events and less-positive economic times. We do not expect many rating changes for reserve reductions as long as the municipality has a clear plan for keeping reserves at a healthy level. Many states have reduced revenue projections from lowered tax rates or economic weakness, and the changes to Medicaid and other federal funding will challenge management over the remainder of the year and into the future.
Longer term, the US is not immune to the global demographic decline in the ratio of working age to retired workers or to the threats and benefits of AI and other technological improvements. At the same time, vigilance over cybersecurity with regard to personal information and the risk to utilities from rogue actors bring further challenges. Over time, these challenges are expected to have an impact on growth in revenues and cause services consolidation. Municipalities that are growing and have deep and diverse economies are expected to prevail, while municipalities with declining populations will be challenged.
At Cumberland Advisors we invest in high-quality munis with an average rating in the AA category that have diverse economies and strong reserves. These types of municipalities generally have more resources to address the upcoming challenges.
Patricia Healy, CFA
SVP, Research
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