As local governments contend with budgetary woes and state property tax reforms, the sector shows signs of weakening. But even with these challenges, some are still bullish on the sector.
The local government sector is entering the "Great Differentiation," said Megan Kilgore, co-founder of BKC Group and former auditor of Columbus, Ohio.
"For much of the past decade, rising revenues and unprecedented federal assistance lifted nearly everyone," she said. "Now those conditions are normalizing, and we'll begin to see which governments built durable financial institutions and which simply benefited from favorable circumstances."
Many local governments face budget issues, including two of the largest cities by population: New York City and Chicago, both of which saw negative rating action during the first half of the year, per Breckinridge strategists.
Moody's Ratings, Fitch Ratings and KBRA lowered New York City's outlook to negative, based on the city's expectations of larger-than-anticipated budget deficits. And a day after the city passed its budget, J.P. Morgan strategists noted New York City could face a downgrade, as the budget relies on one-time measures to close a deficit.
"While upsized city revenues were a positive development, large projected future budget gaps and reliance on non-recurring measures leaves downgrade risk on the table," J.P. Morgan strategists said.
Meanwhile, Fitch and KBRA downgraded Chicago in February.
For Fitch, the downgrade "reflects consecutive operating deficits since 2023, the still high dependence on non-structural solutions and assumptions underpinning the adopted 2026 budget, persistent outyear gaps, and ongoing disagreements between the administration and the city council. These disagreements have impeded decision timeliness and the development of a credible and comprehensive plan to restore structural balance."
And for KBRA, the decision stemmed from the city's deteriorating fund balance, narrowing liquidity and high and rising fixed-cost burden.
These two cities highlight a rising trend within local governments as "growing budgetary pressure is expected in the sector as the economy softens, labor-related, infrastructure, and climate-related costs (including insurance) continue to rise, and federal retrenchment becomes a greater constraint on state aid to locals," said Municipal Market Analytics in a second half 2026 sector outlook.
For some local and state governments, dwindling pandemic-era aid contributes to budget deficits, as cash can no longer "hide the sins" of muni issuers, said Nick Venditti, head of municipal fixed income at Allspring.
With COVID-era aid running out, state and local governments are in a more difficult position than they were several years ago, when the cash hid their expense problems. This will force municipalities, along with states, to stand on their "own two feet again," he said.
The expiring aid comes at a time when the market is experiencing an economic slowdown and is in the middle of a "contentious" midterm election cycle, said Dora Lee, director of research and a partner at Belle Haven.
Altogether, that is forcing budget officials and politicians "who've had … [many] easy budget seasons to weather their first truly hard one," she said.
Budget discipline was even more important this year, labor/staffing remains a top challenge and compensation costs for state and local governments continue to rise, said Tom Kozlik, managing director and head of public policy and municipal strategy at HilltopSecurities.
The firm labeled the local government sector as stable, its base case is "steady and balanced, not spectacular."
Property taxes, Kozlik said, remain the "anchor" of the sector as "home values stay elevated, even as property valuation growth cools in some areas."
However, affordability concerns have spurred at least 17 states to enact or consider property tax relief legislation this year, as such measures to reduce the tax impact of "rapid home-price appreciation relative to incomes" and offer officials a way to deal with cost-of-living pressures, Breckinridge strategists said.
Local governments and school districts are more directly exposed to property tax reform, UBS strategists said, meaning they may be the most at risk for weakened fundamentals from relief initiatives.
For example, credit pressure for some Florida local governments could rise if residents approve a property tax amendment in November, Fitch warns.
The ballot measure "amends the Florida constitution to exempt from property tax the first $250,000 of each home's assessed value (excluding school taxes) … [and] narrows permissible uses for property taxes and limits future assessments," Breckinridge strategists said.
If the measure passes, smaller issuers reliant on residential property taxes face greater exposure than those with diversified tax bases and strong reserves, per Nuveen strategists.
Even with these challenges, some firms still like the sector.
For HilltopSecurities, AI and data center buildout is a potential supportive tailwind, Kozlik said.
There will be around $6.7 trillion of data center infrastructure capex globally through 2030, according to a McKinsey report.
"How much of that lands in any given region in the U.S. will hinge on corporate siting decisions, power and water readiness, and state and local tax structure," Kozlik said.
And for Kilgore, the biggest tailwind is that public finance professionals have improved.
Finance officers today have access to "stronger data, more sophisticated forecasting tools, better governance practices and a much greater appreciation for long-term financial planning than almost any generation before them," she said.
Furthermore, certain things have become the norm rather than the exception: multi-year forecasting, reserve policies, scenario planning and proactive debt management, Kilgore said.
Over the next five years, the strongest credits will be "governments that institutionalize discipline — multi-year forecasting, reserve policies, realistic labor and expenditure assumptions, thoughtful capital planning, and leaders willing to solve tomorrow's problems, even if it means taking baby steps," she said.
