Municipal Bond Market Faces Credit Strain as Federal Aid Ends


The $4 trillion municipal bond market is beginning to show signs of credit strain as the winding down of federal pandemic aid impacts revenue streams. This shift is prompting expectations that the recent trend of rating upgrades surpassing downgrades may soon decelerate.

Revenue growth is stalling in various states, including California, where tax and fee collections are on the decline. Rainy day funds, which had soared to record levels thanks to robust economies and pandemic stimulus money, are projected to decrease.

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“Going into fiscal 2024, we were at all-time highs of reserve funds and the economy had shown resilience,” noted Lisa Washburn, a managing director at Municipal Market Analytics, in a recent interview. “But as we look forward to fiscal 2025, reserves will draw down, and revenue growth will soften.”

While a broad and severe drop in credit quality isn’t anticipated, Washburn does foresee a divergence in specific sectors, particularly in higher education. Municipal Market Analytics has downgraded its outlook for charter schools from neutral to negative.

The report also highlighted that 40% of hospitals were still losing money earlier in the year, although their sector rating was adjusted from negative to neutral. In contrast, the airport sector and essential service providers—such as water, sewer, and electric utilities—are demonstrating resilience, according to Peter Block, managing director for credit strategy at Ramirez & Co. He predicts that pockets of credit stress will surface.

“The vast majority of credit sectors remain stable, but this could change, especially for lower-rated issuers if the U.S. economy enters a recessionary period,” Block said.

The Federal Reserve aims to stabilize the economy while targeting a 2% inflation rate. Although the job market remains robust, a slight slowdown has resulted in some pressure to reduce interest rates.

Credit rating upgrades have outnumbered downgrades by nearly four-to-one in 2023, but this is expected to normalize in 2024, as per a Nuveen report. The upgrade-to-downgrade ratio is likely to return to levels seen in 2015, 2016, and 2018. Through the first quarter of 2023, the pace slowed to two-to-one.

“We anticipate that the pace of upgrades will decrease this year and next, as federal stimulus funding wanes and a potential economic slowdown looms in the second half of the year,” stated Margot Kleinman, director of research for municipals at Nuveen.

Recent months have shown a slowdown in the pace of upgrades, yet they still outpace downgrades by a three-to-two ratio in 2024, according to Nick Kraemer, head of ratings performance analytics at S&P Global Ratings. Local governments are experiencing the most downgrades, although they still maintain a two-to-one upgrade ratio.

Utilities have faced numerous downgrades, along with the education and healthcare sectors, which also have net downgrades by S&P.

Lower inflation could potentially improve outlooks for not-for-profit hospitals, life-plan communities, and higher education. Conversely, a spike in costs could exacerbate expenditure pressures and, subsequently, municipal bond ratings, said Arlene Bohner, head of U.S. public finance at Fitch Ratings.

Moody’s Ratings expects the trend of upgrades outpacing downgrades to persist this year, although the ratio may decline as U.S. assistance decreases and some states encounter budget constraints, according to Susan Fitzgerald, managing director for public finance at Moody’s Ratings. Health care and higher education sectors will continue to face credit challenges.

Most issuers are well-positioned to weather an economic downturn, and more upgrades could arise given that rating actions often lag, stated Nathan Will, head of municipal credit research at Vanguard Fixed Income Group. He added, “We expect the upgrade trend to slow as the economy cools and the remainder of pandemic aid is expended.”

–Assistance provided by Boris Korby.