MUNICIPAL CREDIT OUTLOOK: ASSESSING STABILITY AMID FEDERAL FUNDING AND TAX POLICY UNCERTAINTY
- Matthew Riggle
- May 14
- 3 min read
The municipal market plays a crucial role in the infrastructure of the United States. The $4 trillion municipal market has been partially funded through the Federal government's provisions, which are currently facing uncertainty given recent budget reconciliation talks. The potential reduction of Federal funding, coupled with ongoing discussions regarding the tax-exempt status of municipal bonds, introduces fiscal considerations that warrant close examination. While a reduction in this funding poses potential credit risks, we believe that strong financial positioning and prudent fiscal management will allow most municipalities to weather these changes.
By evaluating the impact of potential funding changes, examining historical fiscal resilience, and analyzing municipal financial management strategies, we aim to provide a comprehensive perspective on the current credit environment. APA’s approach to credit research focuses on identifying high-quality issues with strong financial fundamentals and minimal reliance on federal or state appropriations.
Impact of Federal Funding on State and Local Budgets
Federal funding constitutes a substantial component of state and local government budgets, necessitating an assessment of potential vulnerabilities in the event of funding reductions. Key data points include:
Approximately $1.1 trillion, or 16% of total federal expenditure, is allocated to state and local governments.
Federal funding constitutes an estimated 30% of state budgets.
Local governments receive approximately 5% of their funding directly from federal sources and around 30% from state governments.
While funding reductions may present fiscal challenges, historical trends suggest that state and local governments have employed various strategies to mitigate their impact, including utilizing rainy-day funds and implementing expenditure reductions. Municipalities differ from corporations in that they can cut services as needed to balance budgets or defer infrastructure projects. Municipalities can also generate additional revenues through levying additional taxes, increasing fees, expanding to public/private partnerships (P3), etc.
Potential Implications of Changes to Municipal Tax-Exempt Status
The long-standing tax-exempt status of municipal bonds has been a key factor in supporting investor demand and reducing borrowing costs for state and local governments. Policy discussions have introduced several potential scenarios:
Full repeal with retroactive application – we believe this is an unlikely scenario, given historical precedent and economic considerations.
Grandfathering of existing tax-free bonds – preserving the tax-exempt status of outstanding issuances while affecting new issuances.
Targeted repeal for private activity bonds – potentially affecting sectors such as healthcare, higher education, and airports.
A cap on tax exemption at 28% – a proposal previously introduced by the Obama administration.
We believe the likelihood of a full repeal remains low, and any policy adjustments would likely be implemented gradually. However, changes to tax policy could impact municipal bond yields, market liquidity, and credit quality of specific issues, making continuous credit research more critical than ever.
Municipal Fiscal Resilience and Risk Mitigation Strategies
State and local governments possess multiple mechanisms to manage fiscal challenges and sustain financial stability. These include:
Utilization of Rainy-Day Funds: Increased reserve levels, strengthened by federal COVID-19 relief funds, provide a buffer against revenue shortfalls.
Capital Project Adjustments: The ability to defer or modify infrastructure projects allows for greater fiscal flexibility.
Revenue Diversification: Municipalities can adjust tax structures, introduce new fees, and explore public-private partnerships to generate alternative revenue streams.
Service-Level Adjustments: Expenditure reductions and restructuring of non-essential services can help align budgets with available resources while maintaining core public services.
These strategies have historically contributed to municipal credit stability, differentiating the sector from corporate borrowers facing more rigid financial constraints.
Source: APA Credit Research and Merrit Data, March 2025
APA’s Credit Research Framework
APA employs a systematic and forward-looking approach to credit research with emphasis on the following key metrics:
Liquidity measures
Operating and expense margins
Revenue diversification
Debt service coverage
Reserve and cash management practices
Management efficiency and fiscal policy execution
Our research framework also incorporates ongoing monitoring of legislative developments that may impact municipal tax policy and credit quality. We believe that prioritizing issuers with essential service revenue structures and avoiding excessive reliance on state appropriations helps us reinforce the resilience of our managed portfolios.
Source: APA Credit Research and Merrit Data, March 2025
While uncertainties persist regarding federal funding allocations and potential tax policy changes, the fundamentals of municipal credit remain strong. Historical fiscal resilience, strategic financial management, and proactive adaptation to funding constraints position municipal issuers to withstand evolving economic conditions.
APA remains committed to maintaining a research-driven investment approach, prioritizing issuers with sound financial structures, and continuously assessing policy developments. By emphasizing credit quality and economic resilience and avoiding issuers that rely on federal appropriations, we aim to provide long-term portfolio stability.
APA-2505-20