A Decade of Support
The last 10 years are remarkable for both the consistent improvement in municipal credit quality and the substantial increase in federal funding for state and local governments, which in fiscal year 2024 alone totaled $1.1 trillion, up 44% since 2014. The scope of funding is broad and ranges from entitlement programs (particularly Medicaid) and transportation funding to education and crisis-driven injections like natural disaster relief. State credit quality has benefited, although perhaps at the expense of autonomy: federal grants are their second largest revenue at approximately 36% of total.
A Year of Disruption
In contrast, 2025 saw a downsizing of the federal workforce (Department of Government Efficiency, DOGE, cuts followed by layoffs during the government shutdown), a reversal in policy priorities, diminished federal funding (through grant recissions, delayed payments, and entitlement reform), and an increase in litigation (both lawsuits against the federal government and federal investigations into municipal issuers). We expect these trends will continue in 2026. For example, the council established in January to reform the Federal Emergency Management Agency (FEMA) is set to share its findings in the next few weeks with some form of reduction to federal disaster relief the most likely outcome.
Credit Differentiation
The shift from federal largesse to austerity coincides with tightening budgetary conditions as the post pandemic surge in tax collections has given way to a muted revenue environment while expense growth continues. States are the primary recipients of federal funding and consequently the most exposed, at least initially. However, they are sub sovereign in nature with many levers at their disposal including the ability to raise revenue and cut or delay expenditures. In fact, many have already indicated that they will not replace the federal dollars lost to Medicaid reforms in the One Big Beautiful Bill Act, which bodes well for state budgets as Medicaid accounts for two thirds of federal receipts on average. Instead, we see greater risk at the municipal level where margins are thinner and revenue raising flexibility is more limited. The degree to which these issuers are exposed will depend on how their state governments respond: will they backfill federal funding cuts in whole or in part or will they push them downstream?
One thing is clear: credit differentiation will increase. As states are faced with the difficult task of allocating dwindling financial resources, winners and losers will emerge. Issuers of political and economic importance are more likely to be prioritized than their smaller, rural counterparts. Issuers with moderate leverage profiles will have greater capacity to continue to invest in their infrastructure with new debt if capital grants are cut. For all issuers, nimble management and fiscal discipline will be paramount as will sufficient liquidity to bridge funding gaps in the immediate term.
Investment Implications
Federal retrenchment is a headwind that is not likely to abate in the near term, but most municipal issuers face it from a position of strength. Credit fundamentals remain sound with reserves near their high water mark and positive albeit slowing revenue trends. However, as credit outcomes diverge, bottoms up analysis will become increasingly important both at the time of purchase and throughout the holding period. Close attention should be paid to smaller, disadvantaged issuers with the aim of selling those where credit degradation is already evident. We also anticipate selective buying opportunities as headlines around funding cuts, litigation, and budget deficits drive broad based spread widening.