As pandemic aid wanes and certain municipal bond sectors and issuers face structural weakness, credit performance now hinges on idiosyncratic factors like fiscal stability, geography and management rather than generally favorable conditions.
Credit fundamentals remain strong, supported by "healthy reserves and generally conservative budgeting practices across most state and local governments," but signs have emerged that the "exceptionally favorable post-pandemic credit environment" has started to normalize, Baird Advisors said.
Stimulus dollars are running out just as fiscal year 2027 budgets take shape, coinciding with rising costs for capital projects like infrastructure and a weakening federal-state funding relationship, said Mohammed Murad, head of credit research at PTAM.
Together, these could "impact borrowers whose fundamentals remain weak but who haven't taken the fiscal steps needed to align their operations with their risk profile," he said, noting that changing demographics and the increased frequency and severity of climate-related events could add further pressure to already-tighter budgets.
Some of these factors contributed to Moody's revising its outlook on U.S. cities and counties to negative from stable in late July.
"Rising costs for healthcare, labor and capital investment will drive expenditures higher" at a time when "weakening consumer and taxpayer capacity will likely slow tax growth, limiting revenue gains," the rating agency said.
Moody's outlook shift "matters less for what it says about any single issuer and more for what it signals about the sector as a whole: after several years of steady credit improvement, the easy gains are likely behind us," said BofA strategists said.
The negative outlook most likely signals the direction of ratings over the next 12 months to 18 months, they said.
Like the states, most cities and counties remain on "solid footing" given near-record-high reserve levels and conservative budgeting practices, BofA strategists said, noting the issue is more about momentum.
During the first quarter, Moody's upgraded 208 local government ratings and downgraded 107, compared to the second quarter, when downgrades exceeded upgrades by 116 to 96, reports noted.
Other times downgrades have outpaced upgrades include during and/or just after the Great Financial Crisis and the COVID-19 crisis, said Tom Kozlik, managing director and head of public policy and municipal strategy at HilltopSecurities.
The important message is that relatively stable fundamentals no longer yield uniform credit outcomes, he said.
For example, two credits in the same sector operating in the same state and under similar economic conditions can see diverging credit paths, he said.
Investors looking at them may cluster them together simply because they have the same state behind them, said Tim Iltz, fixed income credit and market analyst at HJ Sims, noting one of the challenges with credit analysis is the temptation to generalize when they do.
"That's usually a trap with munis because even within a sector, you have a wide variety of different types of issuers," he said.
Some sectors facing pressure are higher education and healthcare, both of which saw more downgrades than upgrades in the second quarter of 2026.
Higher ed faces enrollment pressure, changing student preferences, rising costs, and competition, while healthcare contends with labor costs, reimbursement pressure, capital needs, and fiscal management, Kozlik said.
"These developments do not describe a municipal market where credit quality is moving uniformly lower," he said. "This is not a broad-based municipal credit deterioration story."
Most credits continue to demonstrate resilience, but "economic growth and fiscal support are simply no longer enough to overcome structural challenges in certain sectors," Kozlik said.
