Muni credit quality remained strong over the 4th quarter despite some moderating of upgrade activity. Investment grade munis are considered a safe fixed-income investment, with most issuers maintaining strong reserves to help manage through challenges such as changes in federal funding and demographics, cyber threats, and climate disasters. Munis have generally higher credit quality than corporate bonds do with an average rating of AA compared with BBB for corporate bonds. Muni ratings span the spectrum with larger, more diverse munis often better equipped to manage through challenges while smaller and rural munis have less flexibility to address challenges.
The longest federal government shutdown, at 43 days, began October 1 and lasted until November 12. The reduction in Medicaid and SNAP aid to states during the shutdown had states and philanthropic organizations scrambling to provide food and services and straining their budgets. See John Mousseau’s commentary on the history of federal shutdowns Government Shutdowns and Bond Markets.
The shutdown also delayed economic data for munis and the Fed to analyze. Nonetheless, the Fed continued to lower rates in October and December, with other internal Fed data hinting at a slowdown in employment and economic activity. Lower rates contributed to an increase in debt issuance across many sectors, both munis and corporates.
NYC had a historic election of a self-proclaimed socialist mayor, prompting widespread concern about the future of NYC. However, there are checks and balances on the city’s financial operations, and state and control board policies put in place after the 1970s financial crisis that govern tax rate setting. See my commentary NYC Mayoral Election 2025. Mayor Mamdani has put in motion proposals and orders to increase the availability of childcare, protect tenants and increase supply of affordable housing. Some of Mamdani’s policies risk reducing housing supply by making it too expensive for landlords to maintain buildings.
The end of hurricane season came on Nov 30. Although it was an extremely active season with higher wind speeds, no hurricanes made landfall in the US, bringing a welcome reprieve to municipalities and insurance companies. Unfortunately, wildfires, floods, and extreme heat and cold events continue to increase, exemplified by the pummeling of the Pacific Northwest and California this quarter.
During the fourth quarter it was abundantly clear that muni debt issuance volume was going to well surpass last year’s. Total muni issuance in 2025 grew to $575 billion, compared with the average of the past few years of $450 billion. Reasons for the increase include catching up on delayed capital projects and preserving comfortable reserves for spending pressures that likely will result from federal funding changes and potentially slower economic growth.
Upgrade/Downgrade Activity Still Positive but Waning for Munis
S&P reported that for the year through November 30th upgrades surpassed downgrades, while the assignment of negative outlooks exceeded that of positive outlooks. Upgrades were more prevalent in the states and in the housing, not-for-profit, education, and transportation sectors. Downgrades exceeded upgrades in the public power, local government, charter schools, healthcare, and utilities sectors. Moody’s indicated that downgrades surpassed upgrades in the 2nd and 3rd quarters, though some were due to criteria changes.
Sector Outlooks
Most muni sectors have stable outlooks heading into 2026.
The higher education outlook remains negative by most rating agencies due to less student demand from demographics and the restriction on foreign students, who generally pay full tuition and had become a larger fraction of the student population. However, the sector is bifurcated, and opportunities can be found in those institutions with large endowments and strong demand.
School districts have a negative outlook by Moody’s, and S&P sees the sector as “shaky.” The aging of our population and competition from charter schools remain challenges. Charter schools are mostly rated in the non-investment-grade category, with only a few BBB and A ratings; and consequently, school districts remain a safer investment. School districts are funded by property taxes and state aid, and many school district bonds are guaranteed or supported by state programs. Charter schools need to maintain state licenses, are generally highly leveraged, and have real estate risk.
Moody’s and Fitch both have negative or deteriorating outlooks on ports, noting tariff-driven trade headwinds and shifting shipping patterns. This excludes airports, which have experienced upgrades over the past few years.
S&P has a negative outlook on public power, given the large infrastructure financing needs and consumers being more rate-sensitive with affordability at top of mind. Muni utilities have benefited from their rate-setting authority and are generally not regulated by the states, in contrast to investor-owned utilities. High rates or continual rate increases can erode the benefits of autonomous rate-making authority. This could reduce some utilities’ cost recovery and weaken financial margins. Contributing to growing costs are expanding load growth from AI power needs; building resiliency, which includes replacing aging power plants with more-sustainable generation; and other economic activity.
State Rating Changes
A state’s fiscal health can have ramifications for funding decisions at the local level. Federal funding to states, or lack of it, will trickle down to local munis. The healthier a state is, the better positioned it is to set policies that help local munis. Reductions in federal funding or weakening economic growth could result in states making across-the-board cuts in spending, targeted cuts to state agencies, or increases in taxes and fees. The actions that states take in response to the federal changes will be closely watched by taxpayers and market participants. Over the quarter, most state rating actions were positive.
Moody’s upgraded Illinois to A2 with a stable outlook. The upgrade was driven by realized and expected improvement in the state's financial metrics. Illinois continues to add to its reserves and fund balance, growth of which is a crucial element in mitigating risks associated with the state's high leverage, as well as with shifts in federal policy.
S&P revised West Virginia’s outlook to positive from stable and affirmed its AA- rating. The outlook revision reflects that the state will continue to demonstrate an ability to manage its budget through changes in the tax structure, given strong budget management practices and despite weaker economic trends compared with state peers.
S&P revised Pennsylvania’s outlook to stable from positive and affirmed its A+ rating. The outlook revision reflects Pennsylvania's extended impasse in adopting a budget for fiscal 2026. This reinforced governance credit risks, making it unlikely the rating would increase over the two-year outlook horizon. The outlook change affected related securities like the Pennsylvania Turnpike’s AA- rating.
Fitch revised Louisiana’s outlook to positive from stable and affirmed its AA- rating. The revision to positive reflects Louisiana's revenue policy changes that should allow the state to avoid an anticipated fiscal 2026 budget gap and preserve its fiscal flexibility, as evidenced by improved dedicated operating reserve levels.
Muni Credit Quality Outlook
The surprising strength of the economy and the stock market bode well for muni revenue growth from taxes and fees. The changing federal landscape regarding aid to states for healthcare and disaster relief, the ending of pandemic funding, the burden of tariffs, and in some cases the pullback of previously appropriated congressional funding have led to some consternation among those forming budgets. Most states are expected to manage through because of accumulated reserves; and some of the larger challenges, such as having to fund a greater share of Medicaid, will be phased in over a number of years.
Not long ago, many economists were predicting weakness in the economy, and we have recently seen slow growth in hiring while inflation remains above the Fed’s 2% target. If the economy does falter, it will be one more challenge for munis and they may need to adjust expenses should the economy weaken.
We expect the credit quality of municipal bonds to be stable as we head into 2026 but with pockets of weakness as the myriad challenges are addressed. Our stable outlook is based on the high level of reserves at most municipalities, which allows flexibility to address challenges, as well as continued good budget management and improved pension funding practices.
The supply of munis is expected to break another record this year, with estimates ranging from $520 billion to over $600 billion for investment in all types of infrastructure from roads, bridges, and airports to electric power and water systems, after years of underinvestment. The need to become more resilient is also a theme. Resiliency refers to not only hardening systems against climate-related risk but also to the need to invest in cybersecurity and AI. The market expects the Fed to ease one or two more times, so financing costs would be lower and munis would be able to accommodate more bonding.
At Cumberland Advisors we invest in high-quality munis that represent diverse economies and robust financial operations, which give them an average rating of AA. These attributes provide munis with more flexibility to adapt to challenges and opportunitie
Patricia Healy, CFA
SVP, Research
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