As a strategic response to potential changes in economic conditions, members of the municipal bond deal team — issuers, lawyers, advisors, and bankers — should optimize credit structure and disclosure as a way to strengthen investor security comfort and maximize transparency. Municipal bond investors can take steps to mitigate the effects of portfolio devaluation by staying focused on the defensive attributes offered by municipal securities and by seeking strategic deployment of cash where appropriate.
One of my overarching themes for the 2026 municipal bond market identifies active security selection as a key driver for performance, likely to offer greater influence on the investment narrative than interest rates. In my 2026 municipal market outlook, I opined that credit quality, although generally favorable, will make notable shifts this year.
So far in 2026, my outlook for market volatility has been underestimated, thanks to the unforeseen Iranian crisis. Growth expectations are likely to be challenged and inflationary pressure can reassert itself on the monetary policy narrative depending upon the duration of the conflict. Preserving credit quality is especially important when spread differentials become more pronounced with weaker credits potentially exhibiting greater diminution in value. Although municipal bankruptcy filings are rare, elevated consideration may be applied to the possible use of Chapter 9 in certain instances.
The ratio of muni credit upgrades to downgrades will continue to tighten in 2026, with the likelihood of a more balanced relationship. While I expect a resilient credit quality backdrop with continued fiscal austerity, the emergence of sector-specific credit challenges requires greater levels of analytical rigor. I would not be surprised to see elevated defaults and impairments across certain highly speculative structures, such as project finance, conduit housing bonds, charter schools, and lower-quality healthcare/senior living financings. An adverse shift in the economic trajectory could increase technical defaults, with a higher percentage of this cohort falling into actual monetary default.
Times of credit stress may shift the conversation to municipal bankruptcy. However, application is limited in scope, and history tells us there is not a "one-size-fits-all" approach. Pursuant to the U.S. Bankruptcy Code, states are not permitted to file bankruptcy given their sovereign status. Municipalities can generally file under Chapter 9 of the U.S. Bankruptcy Code with provisions often complex and typically set by state statute, subject to certain requirements.
In addition to meeting an insolvency test that is typically tied to a municipality's ability to repay its debt, a bankruptcy candidate must also submit various documentation to the bankruptcy court as well as a plan detailing how it would work with its creditors in good faith upon emerging from bankruptcy. The Bankruptcy Code defines a "municipality" as a "political subdivision or public agency or instrumentality of a state."
Not all states authorize the use of Chapter 9. According to the Illinois Policy Institute, 10states allow unconditional Chapter 9, 14 states permit conditional Chapter 9, four states maintain very limited access to Chapter 9, and 22 states prohibit Chapter 9. Underlying the historically low default rates and high recovery experience for municipal bonds is the fact that municipal governments are ongoing enterprises that cannot simply go out of business like corporate entities can. Municipalities are subject to different bankruptcy laws than corporations.
These laws help mitigate the credit risk associated with municipal bond investment. Corporations have the ability to file bankruptcy under Chapter 7 (liquidation) or Chapter 11 (reorganization). While Chapter 9 generally permits the restructuring of a municipality's debt, it does not allow creditors to force its liquidation. Furthermore, a municipality would typically retain its powers under Chapter 9, such as the ability to levy taxes. It is these distinctive bankruptcy differences that enable a municipality to preserve operational status with continued revenue-generation capacity.
Isolated municipal bankruptcy filings do occur, with the municipal bond market experiencing Chapter 9 filings from Detroit, Michigan; Vallejo, California; Stockton, California; Orange County, California; and Jefferson County, Alabama. In 2011, The Harrisburg, Pennsylvania, city council voted to file Chapter 9 over $300 million of debt associated with the city's failed incinerator facility. The case was dismissed by a federal bankruptcy judge as the filing lacked sufficient authorization from the state. Under the state's oversight, Harrisburg was placed in receivership with its financial operations restructured outside of bankruptcy.
The industry's largest and most followed bankruptcy involves the restructuring of Puerto Rico's $70 billion-plus debt under the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). PROMESA represents special legislation designed to provide a bankruptcy-like mechanism for reducing the commonwealth's (with application to other U.S. territories') debt burden as the U.S. Bankruptcy Code precluded Puerto Rico's access to Chapter 9.
PROMESA envelops multiple issuers and structures with different settlement outcomes based on individual creditor classes and liens. The Puerto Rico Title III experience also establishes case law surrounding the treatment of special revenue bonds, with the automatic stay allowing, but not requiring, debt service payment on certain structures. This nuanced outcome can have future implications for other special revenue bond financings outside of Puerto Rico even though the ruling is not binding on other court jurisdictions.
While much of the commonwealth restructuring has been completed, the Puerto Rico Electric Power Authority is still moving through the bankruptcy process. The PROMESA Title III restructuring and litigation is ongoing, making this bankruptcy suitable for its own commentary given its breadth and depth and overall impact upon the municipal bond market.
Future Chapter 9 filings can be expected with limited frequency. Most should be confined to those issuers having limited financial flexibility given structural deficits, a shrinking tax base with a lack of employment diversification and outsized unfunded pension liabilities. Furthermore, exposure to event risk (e.g., recession, natural catastrophe), deliberate or unintentional fiscal malfeasance, a failed municipally-owned enterprise, and/or a weakened capital structure can result in a filing. For these types of issuers, bankruptcy may be the only remedial option.
Thus far, Chapter 9 experience has not created a meaningful and lasting repricing of the municipal market. Again, Chapter 9 is limited against a backdrop of 50,000 issuers, with just over half of the states authorizing a filing to varying extent. Additionally, states generally assume an interventionist role before a municipality's financial challenges reach crisis proportions. Chapter 9 is a product of the "Great Depression" and was initially crafted to end protracted litigation against those municipalities not honoring their debt obligations. The intent was to provide municipalities with time to develop a viable remedial plan.
While municipal bankruptcy does not necessarily have to be a death knell, I continue to view its use as limited in scope and I do not believe allowing states access to Chapter 9 is prudent. If states were allowed to file Chapter 9, there would be far less incentive for certain state officials to make the hard decisions to address structural imbalance, pension reform and prudent debt management. State bankruptcy would have far-reaching implications for multiple stakeholders, including bondholders, pension beneficiaries, unions, essential service providers and, of course, politicians.
One would have to wonder if local governments would push their states harder for changes to bankruptcy allowances should states themselves be given a green light to file. While precedent is limited, bondholders are generally treated less favorably in bankruptcy than are pension beneficiaries, but there have been some adverse rulings against the pension beneficiaries themselves, which can be a measure of security structure. Let's all remember that pension beneficiaries vote. States control their revenue streams and could be compelled to raise taxes under unlimited tax GO structures. This may not be politically palatable, but this is a fact.
It is my recollection that Senate Majority Leader Mitch McConnell (R-Ky.) introduced legislation to grant states access to Chapter 9 in the spring of 2020, during the heart of the COVID-19 pandemic. While recognizing that the economic suspension placed unprecedented stress upon state budgets, I did not support this initiative as a means to resolve a state's financial difficulties. I viewed the legislative, and perhaps judicial, road to authorizing state bankruptcy as a difficult and unlikely journey. Political motivations may play out here as bankruptcy could weaken public unions given that labor contracts can be rejected in bankruptcy.
Granting states access to Chapter 9 would require an amendment to the U.S. Bankruptcy Code. A revised Municipal Bankruptcy Act was enacted by Congress in 1937 and upheld by the U.S. Supreme Court, which ruled the legislation did not interfere with the sovereign powers of the states, which are guaranteed by the 10th Amendment.
The 10th Amendment empowers the states to control their own fiscal affairs, and sovereign entities do not legislate bankruptcy regulations upon one another. In the unlikely event that federal legislation establishes a pathway to bankruptcy for the states, amendments to state constitutions or statutes would likely be needed for ultimate authority.
When the idea of enabling states to file Chapter 9 was floated during the Great Recession, it was dismissed by major stakeholders including bondholders, public employee unions, and virtually all governors who understood the implications of a filing, not the least of which would be higher borrowing costs down the road and maybe loss of market access for a period of time. Industry groups, such as NAST, NGA, and GFOA, label these proposals "irresponsible" and believe that state access to Chapter 9 would catalyze unnecessary market volatility.
A similar reception was given to Sen. McConnell's proposal, with eventual allocations of federal stimulus funds and the establishment of the Federal Reserve's Municipal Lending Facility (MLF) made available to state and local governments. I would note that utilization of the MLF, designed to supplement cash management liquidity needs, was very low, but it did serve to create market stability, tightening yields and ratios.
Authorizing state access to Chapter 9 would have far-reaching disruptive implications for the municipal market. Any serious notion that states may have the ability to restructure their outstanding debt would likely force municipal bond yields higher as the market reprices itself to reflect this new risk.
Primary market access would become more limited for state and local issuers and secondary market activity would experience constrained liquidity. Higher borrowing costs would burden already strained budgets. Furthermore, state debt service requirements account for, on average, 4% of overall spending. Thus, I do not think states would compromise market access for a relatively small expenditure item.
States consistently demonstrate both the ability and willingness to meet full and timely debt service obligations. States maintain effective cash management tools and the ability to effect emergency appropriations to help ensure continued debt service. Bondholders enjoy additional comfort as state general obligation debt service often receives high priority of repayment given constitutional and statutory provisions, and states display strong "rainy-day" funds.
Having said this, slower economic growth with geopolitical uncertainty can impact state revenue performance and complicate budgetary forecasting. Certain states are impacted more heavily by the volatility within the financial markets — which has direct implications for various types of tax receipts — and pension fund investment performance can come under pressure more broadly. Depending upon the severity of economic decline, some states may weigh critical decisions over meeting payroll and essential service needs at the expense of possibly reducing required contributions into the pension system.
