The events of the quarter include DOGE and tariff actions, the reassessing of and halting of subsidies, and the functioning and funding of major spending programs, e.g. Medicaid and education priorities, among many other changes from Trump 2.0 that will challenge municipalities. These challenges come on top of the runoff of pandemic aid, increasing natural disasters and weather risks, and the need for continued vigilance to protect against cyber threats. Change is constant, but so many changes all at once are unusual. Thankfully, many municipalities have amassed strong reserves and practice good budget management.
Trump 2.0 has many complaining and hopefully thinking about better ways to do things instead of following the status quo. Some have called the moves revolutionary – which may be a good thing, since we have had a slow creep of policies over the past 30+ years that are in need of review. The recent actions by DOGE are seemingly more about reducing headcounts and rooting out fraud and less about reimagining how government can run more efficiently. That could be the focus of the next stage, and Congress may reevaluate legislation regarding administrative agencies.
As we have noted in the past, municipal management is enduring the burden of increased bureaucracy without having to address conflicting or old requirements. Many municipalities are buried in paperwork rather than out building capital projects and providing useful services. Philip Howard and Common Good are working to educate federal, state and local governments and other leaders on ways to approach the problem. See “Federal Government Efficiency Commission Trickle-Down to State and Local Municipalities.”
We did not foresee the extent of Trump’s ever-changing tariffs– and the long-term ramifications, let alone the effects of the short-term turmoil, remain to be seen. The release on “Liberation Day” contained items not expected; and companies, municipalities, analysts, and pundits continue to discuss how the changes could affect operations and profitability. See Cumberland Chief Economist David Berson’s informative commentary “Tariffs!”
Municipalities were already grappling with budget challenges with the end of pandemic aid, along with inflation in goods, services, and especially labor. Many had planned for the inevitability of these developments, and many have large reserves. Some have needed to make cuts, and others have had to or plan to draw down reserves and raise taxes. In some cases, there will be downgrades unless the affected municipality can show a clear path to restoring reserves and budget balance.
Kansas was the first state to have an S&P negative credit action driven in part by potential Trump administration policies that could dampen economic growth and pressure finances. In April, the state’s AA- S&P rating outlook was reduced to stable from positive, reflecting an evolving budget environment created by the state’s recently enacted tax relief package and potential actions taken at the federal level that could create a weaker revenue environment and budget pressure for the state, making it more challenging for it to address projected structural budget imbalances.
Meanwhile, Washington DC’s rating was put on review for a downgrade by Moody’s, given the drastic cuts to the federal workforce, which have an outsized impact on the District’s economy, finances and employment. Fitch also placed DC on rating watch negative, noting yet another challenge to the district of the potential reduction in federal funding that the federal government may impose.
The wildfires in Los Angeles resulted in an S&P two-notch downgrade to the Los Angeles Department of Water and Power’s power system bonds to A from AA- and its water system bonds to AA- from AA+, as the systems share management and other resources. Both were also put on CreditWatch negative. In addition to the potential liability for possibly being responsible for the fires, the rating agency noted the increasing frequency and severity of highly destructive wildfires within LADWP's service territory and their recent spread into more urban areas. Final determination of liability may result in the removal of the CreditWatch negative. Other rating agencies also took negative actions on the credits.
Trickle-down
Changes to federal funding of state and local governments are being discussed, including large programs related to Medicaid and education. Each state has their own system for funding programs and local governments – municipal finance is never one size fits all, making the evaluation of potential changes complicated. S&P reported that, on average, US states receive more than 30% of their operating revenue from the federal government, while US local governments receive less than 5%. However, 30% of local government operating revenue comes from state sources.
States may implement budget changes to address federal funding changes, and those will trickle down to local government, as well as to educational and healthcare institutions, housing programs, and infrastructure funding (maybe upkeep of roads will be reduced), and the list goes on. In past recessions, states have made budget choices to reduce funding to some or all programs, but they have also provided support to local governments or sectors that may be more affected by economic weakness or other types of revenue shortfalls.
Pensions funding has become more disciplined, because large future liabilities need to be addressed. There is more transparency in financial reporting, which allows stakeholders to keep governments accountable to citizens. A challenged revenue picture, either from federal actions or economic weakness, could make it tempting for a municipality to not fully fund annual contributions to a plan whose payments are due far into the future, in order to fund immediate needs. The stock market downturn and increasing investments in alternative assets are also elements that may affect pension funding levels and the estimation of future liabilities that need to be managed.
Tax Exemption
In addition to the challenges faced by municipalities previously noted in this commentary, the elimination of municipal bond tax exemption is being considered, which would increase financing costs for municipalities. For a detailed discussion of the issues and our view on the risk to tax exemption, see Ben Pease’s commentary “Municipal Bond Tax Exemption.”
ASCE Report Card
Every four years we await the American Society of Civil Engineers (ASCE) report card on Americas infrastructure – a vast interconnected system of highways, streets, public buildings, mass transit, ports, airports, inland waterways, dams, levees, water systems, waste facilities, the electric grid, broadband networks, and other public and private facilities. As ASCE notes, maintaining these networks is essential to meet economic demands and protect public health and safety.
The average grade for infrastructure has been improving, from D+ in 2017 to C- in 2021 and to C in the 2025 report card. The improvement reflects increased investment from federal, state, and local stakeholders. However, a grade of C is considered mediocre, and continued improvement is needed. The Infrastructure Investment and Jobs Act and the Inflation Reduction Act provided substantial funding; and municipal bond issuance, which funds most of our infrastructure, has averaged $450 billion a year since 2019.
Tax-exempt municipal bonds are an important tool for improving our infrastructure, and the lower financing costs made possible by federal programs make projects more affordable to taxpayers and ratepayers.
State Rating Changes
Oklahoma was upgraded to AA+ by S&P, reflecting the state’s consistently positive financial results and management's commitment to the structural stability of its finances, demonstrated by its contributions of revenue windfalls for one-time purposes and the progress made toward fully funding pension liabilities. The state has strong reserves that should help cushion cyclical revenue swings from economic or energy-related pressures.
Municipal bond upgrades continue to surpass downgrades, but the challenges faced by municipalities are numerous. The federal funding of programs and the effect of tariffs remain to be seen. We will watch developments and the reaction of state and local governments as well as healthcare and higher education institutions to the coming changes. Many munis, especially the ones that Cumberland Advisors invests in, with an average rating in the AA category, should be able to weather the storm.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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