Executive overview

Questions about municipal credit conditions for U.S. states, local governments, and their enterprises (collectively, “municipalities”) have arisen in light of the 2024 elections. The overall effect on most municipalities seems likely to be manageable, but not all municipalities are created equal. While monitoring the ongoing evolution of credit conditions within the municipal bond market, Schwab Asset Management’s credit research team helps the portfolio managers for our Wasmer Schroeder^™ Strategies and other fixed income products manage credit risks by emphasizing prudent credit selection, portfolio diversification, and ongoing monitoring to navigate evolving credit developments. In this paper, we explore many of these issues.

Question 1: What federal policy issues may be in play following this election cycle, and what are the potential implications for municipalities?

Downstream effects from federal policy changes can be nuanced and are likely to impact municipalities differently, depending on their sector, demographics, local economies, and geography.

• Immigration—Population inflows can bolster the labor market by adding to the workforce, but reducing in-migration may also increase unemployment or inhibit economic growth. At the same time, immigration has led to additional budget costs for municipalities, such as providing supportive housing, social services, and healthcare for some migrants.
• Trade policy—New trade protections, including either broad or targeted tariffs on foreign goods, are highly likely. Tariffs generally increase prices paid by U.S. consumers, creating inflationary pressure that may weaken economic growth and pressure interest rates higher. This can potentially reduce a municipality’s purchasing power, pressuring wages higher, or raising bond market borrowing costs.

Nevertheless, we believe that the vast majority of municipalities are well positioned to manage these potential changes in federal policy. For instance,  municipal revenues generally lag or are insulated from economic volatility, giving them time to adjust their budgets if economic conditions weaken. Consider property taxes, for example, which are tied to assessed values that usually lag or have other buffers against property value changes, or income taxes, which are based on prior years of income. In addition, municipal enterprises like utilities provide essential services that customers always need, even if the economy deteriorates.

As illustrated on a state level in Exhibit 1, municipalities entered this election cycle in a very strong position as many have bolstered financial reserves using recent federal pandemic aid and benefitted from a positive economic backdrop after the COVID-19 pandemic. Most states have high credit ratings in the double-A and triple-A categories and currently enjoy record-high rainy-day reserve funds that provide financial cushion.

Exhibit 1: Rainy-day balances at all-time highs for many states

Sources: The Pew Charitable Trusts; Schwab Asset Management. For more information, see: https://www.pewtrusts.org/en/research-and-analysis/data-visualizations/2014/fiscal-50/reserves-and-balances.

The bottom line: Despite the prospect of federal policy changes, municipalities entered this election cycle in a very strong position and benefitted from a positive economic backdrop after the COVID-19 pandemic.

Question 2: To what extent will large federal budget deficits impact areas of the municipal bond sector that rely on federal funding?

As shown in Exhibit 2, the federal budget deficit remains extraordinarily high, even with the expiration of federal COVID-19 pandemic relief funds distributed to municipalities in 2020 and 2021.

Exhibit 2: The federal government has recorded 23 consecutive deficits

Sources: Department of the Treasury, FiscalData, Treasurygov; Schwab Asset Management. For more information, see: https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/.

Municipal sub-sectors such as healthcare, housing, and some transportation areas that receive integral funding from longstanding programs may come under pressure as Congress considers deficit reduction measures. As shown in the exhibit below, the federal government provides about $1.1 trillion annually in grants to states and local governments, just over half of which is Medicaid funding. Other sizable programs support housing and transportation infrastructure.

Exhibit 3: Federal aid provides significant funding for social services and infrastructure

Sources: Office of Management and Budget (Table 12.3); Schwab Asset Management. For more information, see: https://www.whitehouse.gov/omb/budget/historical-tables/.

Municipal issuers that are the most exposed to federal funding program reductions include the following:

• Not-for-profit healthcare providers—Receive significant revenue from Medicare/Medicaid reimbursement-based payments to cover services, which can lead to thin operating margins. Many hospitals with weak payor mixes are more reliant on supplemental funding, such as Medicaid disproportionate share payments or provider tax programs, which are susceptible to federal policy changes.
• Housing finance agencies—Support single and multi-family housing markets by issuing revenue bonds secured by mortgages. These agencies have exposure to the federal government, which provides significant assistance to the housing market through guaranteed mortgages and credit enhancements, insurance, or rent vouchers for low-income families.
• State Transportation Departments—Utilize Grant Anticipation Revenue Vehicles (GARVEE) bonds secured by federal highway funds that provide current financing in anticipation of future federal grant receipts for road projects. Federal grant funds pay debt services on these bonds, although the federal government is not obligated to provide funding past current authorization cycles (typically six years).

Apart from the above referenced sub-sectors, it is important to emphasize that most municipalities benefit from budget authority that is managed apart from the federal government. Taxes and user charges (and state aid for some sectors like school districts) generally fund operations and debt, while federal funds may provide supplemental support.

Moreover, material constraints to provide public services are not generally imposed on municipalities, affording some ability to trim spending on services if revenues go largely unrealized. Nevertheless, a small share of municipalities may not manage potential federal funding reductions well, raising the possibility that their credit quality could potentially weaken. However, municipal bond investors have the opportunity to help mitigate exposure to these risks by employing portfolio management teams that are backed by professional credit research teams assisting in the ongoing monitoring and selection of municipal securities.

The bottom line: Large federal deficits do not tend to materially impact near-term credit quality for fiscally responsible municipalities, but sub-sectors that receive significant federal funding should be looked at more closely.

Question 3: How might the municipal bond sector be impacted by tax policy in 2025?

The elimination/limitation of the income tax exemption for municipal bonds is occasionally entertained as the exemption reduces revenue for the federal government. Congress has projected that the exemption will cost the federal government $125 billion in foregone income tax revenue for 2023-2027, and the topic may reemerge as a proposed way to reduce deficits or offset other tax breaks. We expect that limiting/eliminating the tax exemption for municipal bonds would significantly impact municipal market dynamics, including increasing the value of outstanding tax-advantaged bonds. Municipalities would continue to issue debt but likely at higher interest rates to compensate investors for taxable income. Higher interest costs would potentially drive higher debt burdens and reduce financial flexibility for some municipalities, which could weaken their credit quality over the long term. However, tax policy changes for municipal bonds have historically been infrequent and limited in scope, given that municipalities are responsible for most of the nation’s critical infrastructure and social services.

Also, the Tax Cuts and Jobs Act (TCJA) of 2017 has resulted in lower federal income tax rates in exchange for fewer tax deductions, among other policy changes. Most states that levy income taxes conform to the federal tax code in some fashion, leading to lower exemptions and higher state income tax liabilities for many filers and a positive swing in income tax receipts for a number of states since 2018. A number of TCJA provisions are set to expire in 2025, but the new Congress is expected to revisit, and likely extend, these policies before they expire.

The bottom line: The likely extension of TCJA provisions and high deficits may lead to scrutiny for the tax exemption for municipal bonds, which could lead to higher borrowing costs and credit pressure on some municipalities.

Question 4: How has municipal credit quality been affected by extraordinary federal grant support in recent years and what are some examples?

Municipalities have historically received extraordinary support from the federal government in times of crisis, but fiscal pressures from large deficits and a growing debt burden could potentially affect the federal government’s ability and willingness for this paradigm to continue. As shown in the exhibit below, the Congressional Budget Office forecasts record debt-to-GDP levels in the next decade.

Exhibit 4: Federal debt has swelled since 2020, and the debt burden is projected to grow

Sources: Congressional Budget Office, The Budget and Economic Outlook: 2024 to 2034; Schwab Asset Management. Results for 2024 to 2034 are projected. For more information, see: https://www.cbo.gov/publication/59710.

States and local governments have benefitted from substantial temporary federal support, including Federal Emergency Management Agency (FEMA) assistance in the wake of natural disasters. This federal backstop supports municipal credit quality by providing resources to help municipalities manage through natural disasters.

However, future disaster aid might become less generous as extreme weather events become more common and recovery costs rise.

In addition, several large federal stimulus packages were approved in recent years that temporarily support the economy, and include aid that is supportive of municipal credit quality:

• The Coronavirus Aid, Relief, and Economic Security (CARES) Act, CRSSA, and ARPA—Included over $500 billion of temporary aid for municipalities that they need to wean themselves from in planning for future budgets. Prudent municipalities used relief funds for targeted purposes or built-up reserves, but some used relief funds to pay for basic operations or social programs that will be difficult to maintain once aid runs out.
• Infrastructure Investment and Jobs Act (IIJA)—Included $550 billion for new initiatives over a five-year period to rebuild roads and bridges, improve transit, provide clean water, enhance climate resilience, and support other infrastructure projects. Grants and other mechanisms will somewhat reduce future debt burdens for municipalities that receive funding.
• Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act—Involved $280 billion in legislation to bolster the competitive advantages of the U.S. over a ten-year period in the research, development, and production of chips that have become commonplace in electronics. This legislation does not drive direct aid to municipalities but nevertheless supports state and local economies indirectly by stimulating technology sectors and the nation’s innovation hubs.

We expect that many municipalities should be able to manage through less generous future federal funding given that they entered this election cycle in a very strong position. In addition, local control of many municipalities’ revenue streams and their budgets can help maintain fiscal discipline.

As shown in the exhibit below, Moody’s quarterly rating changes indicate that credit rating upgrades outpaced downgrades every quarter since 2021.

Exhibit 5: Municipal credit quality trended positively over the last four years

Sources: Moody’s Ratings, Moody’s Quarterly and Annual Municipal Rating Revisions; Schwab Asset Management. For more information, see: https://www.moodys.com/research/Public-Finance-US-Rating-revisions-Upgrades-continue-to-outpace-downgrades-Sector-Profile--PBM_1417420#290612199861c31d1036b185b4e69b75.

The bottom line: Many municipalities should be able to manage through less future federal funding, although for investors who are concerned about such potential developments, professional credit and portfolio management might help.

Question 5: Will municipal credit conditions face spillover effects from large federal budget deficits, a growing federal debt burden, and potential changes to the U.S. sovereign credit rating?

Municipal credit quality has historically remained largely insulated from large federal budgets deficits and downgrades to the U.S. sovereign rating by the rating agencies. Despite some correlation between the U.S. sovereign and municipal ratings, the vast majority of municipalities have substantial autonomy, so their credit quality does not move in lockstep with that of the U.S. government. Municipal budget authority is managed apart from the federal government, allowing municipalities to independently raise taxes and other revenues pledged to bondholders under state or local law. Therefore, ratings for municipalities can potentially be higher than those of the U.S. government.

Exhibit 6: Most municipal bonds repaid from locally sourced revenues

Sources: Moody’s Ratings, Moody’s Quarterly and Annual Municipal Rating Revisions; Schwab Asset Management. For more information, see: https://www.moodys.com/research/Public-Finance-US-Rating-revisions-Upgrades-continue-to-outpace-downgrades-Sector-Profile--PBM_1417420#290612199861c31d1036b185b4e69b75.

However, some municipalities that are more dependent on significant federal funding—namely in the healthcare, housing, and some transportation areas—will be more exposed to federal funding cutbacks or downgrades to the U.S. sovereign credit rating.

The bottom line: Municipal budget authority is managed apart from the federal government, allowing municipalities to raise revenues pledged to bondholders; however, municipalities dependent on federal funding could face weaker credit quality and lower credit ratings if federal fiscal challenges persist, underscoring the importance of professional credit selection and monitoring.

Municipal credit considerations going forward

Vigilant, dedicated credit research is critical for municipal bond investors. Municipalities are by and large high-quality bond issuers, but the sector is very diverse, highly nuanced, and has pockets of risk that require thoughtful consideration and navigation. Different sectors of the municipal market, let alone individual issuers, are likely to manage through the effects of potential federal policy changes more effectively than others. In addition, each investor has a unique situation, and a professional manager can provide security selection and ongoing credit monitoring for any tax policy changes that may impact municipal bonds.

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