Credit quality in the $4 trillion municipal bond market is beginning to show signs of strain as federal pandemic assistance phases out, marking a potential shift from years of predominantly favorable rating trends.
The easing of revenue growth, particularly evident in states like California where tax and fee collections are declining, coupled with forecasts of diminishing rainy day funds after reaching record highs due to robust economies and federal stimulus, underscores mounting pressures on municipal finances.
Lisa Washburn, managing director at Municipal Market Analytics, noted, “As we enter fiscal 2025, we anticipate a drawdown of reserves and softer revenue growth, following all-time highs and resilient economic conditions in fiscal 2024.”
While a significant decline in overall credit quality isn’t anticipated, Washburn highlighted sector-specific divergences, particularly in higher education. Municipal Market Analytics adjusted its outlook for charter schools from neutral to negative, reflecting nuanced shifts within the market.
Similarly, Peter Block, managing director for credit strategy at Ramirez & Co., observed strength in sectors such as airports and essential services like water, sewer, and electric utilities. However, Block cautioned that localized credit stress could emerge.
Despite the Federal Reserve’s efforts to stabilize the economy amid inflation concerns, the pace of credit rating upgrades, which outpaced downgrades by nearly four-to-one in 2023, is expected to normalize. Margot Kleinman, director of research for municipals at Nuveen, highlighted that the ratio of upgrades to downgrades is aligning with levels seen in earlier years.
Looking ahead, Nick Kraemer, head of ratings performance analytics at S&P Global Ratings, noted a moderation in the rate of upgrades in 2024, although upgrades still surpass downgrades, particularly in sectors like local government.
Arlene Bohner, head of US public finance at Fitch Ratings, suggested that lower inflation could offer relief to sectors like not-for-profit hospitals and higher education, while heightened costs might intensify expenditure pressures and, subsequently, credit risks.
Despite the anticipated slowdown in the pace of upgrades, Moody’s Ratings expects the trend of upgrades outweighing downgrades to persist, albeit at a reduced rate, reflecting ongoing fiscal challenges for certain states and sectors.
Nathan Will, head of municipal credit research at Vanguard Fixed Income Group, emphasized that while many issuers are resilient, future upgrades may taper as economic conditions cool and remaining pandemic aid diminishes.
In summary, while the majority of the municipal bond market remains stable, the gradual reduction in federal support and economic uncertainties pose challenges that could temper the pace of credit upgrades moving forward.
