Municipal Credit Remains Firm

Municipal credit remains strong as we enter 2026, despite a tumultuous 2025. We see a soft landing as the most likely economic scenario given the resilience of economic activity and easing of inflation. In this scenario, growth will continue to slow, reaching below trend, and unemployment will continue to rise modestly, but not to recession levels.

Our 2026 outlook is only slightly adjusted compared to last year’s, as municipal credits remain resilient. This stability reflects continued high reserve levels that, while a touch lower than last year, continue to provide an ample cushion against economic or event risks.

Risks to federal policy changes have ebbed, although the potential for volatility remains. The passage of the federal tax bill, which left taxation of municipal bonds unchanged, resolved many unknowns. Yet it put slow-moving cuts into place for Medicaid and food stamps, and it added pressure to states, hospitals and universities. The period around the November election could see increased volatility, as investors assess how the next Congress may increase or decrease pressure on states, hospitals and universities. 

State and Local Government: Balance

Outlook

We maintain our stable outlook in 2026 for state and local governments, including school districts, although we observe rising pressures on the sector. Stability stems from reserves remaining near record levels and continued strong tax revenues which are bolstered by robust equity market returns. California, for example, has posted 9% revenue growth over last year through the first five months of fiscal year 2026. Pressures arise from federal policy changes made in last year’s tax bill, including shifting the cost of safety net programs like Medicaid and Supplemental Nutritional Assistance Program (SNAP, or food stamps) towards state and local budgets. Yet the full force of these cuts will not take effect until 2027, giving states time to adjust the programs. Tax revenues, rather than federal funds, are the main source of operating collections for the sector, and weakening economic outlooks are in focus with increased layoff announcements, moderating inflation, in addition to federal income tax code changes that can impact state budgets. For example, Colorado projected a nearly 10% reduction in income tax collections due to conforming with federal calculations.

Local government budgets and reserves also remain stable, but budgetary pressures are increasing as pandemic-era stimulus funding was exhausted. Affordability for residents remains top of mind, with high home prices and rising climate risk driving higher property tax levies and insurance costs. Homeowners continue to seek relief from these costs. States such as Texas and Indiana have expanded property tax exemptions, while others, like Florida, are debating eliminating the revenue source entirely. The sluggish rebound in commercial real estate values is also pressuring governments that rely on this tax base. Strong investment gains and better funding discipline have improved pension funding levels for both states and local governments, as shown by Illinois’ fourth consecutive decline in unfunded liabilities through June 2025. School districts face the highest pressure, in part because reduced immigration is contributing to enrollment declines. Chicago Public Schools reported a 2% decline in Fall 2025 enrollment after two years of growth. School districts also face exhaustion of stimulus funds, reduced state appropriations, and growing school choice that diverts public school funding to charters and private schools.

Resiliency

Resiliency remains high due to reserves, improved pension funding, revenue raising flexibility, and available management tools that can stabilize finances in the event of an economic downturn, federal policy change or natural disaster. The National Association of State Budget Officers reports state rainy day fund medians of nearly 13% of annual spending, above the pre-pandemic levels of nearly 8%. We expect state and local governments to utilize these reserves modestly in 2026 as reductions in federal funding shifts costs to states. We continue to monitor impacts of climate change with the number of billion-dollar disasters increasing annually and potential limits to the availability of federal assistance.

Healthcare: On the Mend

Outlook

We have a stable outlook on the healthcare sector, anchored by essential service demand and historically strong balance sheets. These strengths provide a solid foundation as the sector faces ongoing challenges from elevated expense growth and policy changes. Many large systems are well-positioned to adapt and maintain stable performance, yet smaller and rural providers with thin margins and limited revenue diversification are exposed to greater volatility.

Operating margins across the sector have stabilized and are expected to improve modestly through 2026 but remain below pre-pandemic levels. Revenue growth now outpaces expenses, supported by growth in outpatient services, expansion of high-demand specialties, and some hospitals benefiting from more favorable rates with commercial insurers. Elevated expenses continue to weigh on performance however, driven by wage pressure and inflation in supplies and drugs. As hospitals increasingly focus on cost containment and workforce stabilization, expense growth is expected to continue to moderate gradually, which remains key for operational improvement.

Policy and regulatory uncertainty remains a key risk. Medicaid funding changes under the federal tax bill will not affect 2026 materially given the lag in their implementation, but they are expected to pressure margins in 2027 and beyond. Hospitals with large Medicaid populations and limited financial flexibility, such as safety net hospitals, are most vulnerable to Medicaid cuts, while large, diversified systems will be better positioned to absorb the impact. Additional policy headwinds include the upcoming expiration of Affordable Care Act subsidies, which is expected to increase uninsured rates, and the continued reassessment of the 340B drug discount program, which is a crucial income stream for safety net providers.

Healthcare issuance increased 14% in 2025 (through mid-December) following a 151% rebound in 2024. We expect issuance to remain strong in 2026 given significant pent-up capital needs. Focus areas for capital spending include outpatient expansion, investments in technology and infrastructure upgrades.

Resiliency

The sector’s resilience is underpinned by its essential-service role with strong demand, healthy revenue growth and historically strong liquidity with nearly 200 days cash on hand at fiscal year-end 2024. Liquidity is expected to remain stable through 2026, providing a healthy buffer against ongoing expense pressures and policy uncertainty. Large health systems are particularly well-positioned, benefiting from diversified revenue streams, scale advantages and proactive cost management, while smaller and rural hospitals face greater vulnerability. Providers have a long history of responding to policy changes, and the sector demonstrates adaptability through strategic partnerships, technology adoption and disciplined expense management.

Transportation: Cruising Altitude

Outlook

The transportation sector outlook remains stable, in line with our economic forecast of a soft landing. Expected GDP growth in 2026 should maintain steady passenger traffic and support sector stability. There is a bifurcation as airport and toll road traffic has reached record levels, mass transit ridership is recovering but still well below pre-pandemic levels and port volumes are pressured due to rising tariffs.

• Airports: We expect stable enplanements in 2026. 2025 demand was varied with strong premium, business and international travel but weaker budget and domestic segments. Airports with more legacy carrier exposure were more resilient than low-cost carriers and benefit from loyalty programs, premium services and international routes. Stable traffic supports credit fundamentals even with a modest increase in leverage due to larger capital plans as many airports extend long-term airline agreements to align with their capital strategies.

• Toll roads: We anticipate modest traffic growth and inflationary toll increases will help maintain stable finances. Vehicle miles traveled is expected to increase modestly, reflecting slow but steady macroeconomic expansion and low population growth. Changes to trade policy may negatively impact commercial traffic. The sector is likely to maintain strong coverage and liquidity, although rising project costs could increase leverage. Toll road traffic is less volatile than the other sub-sectors, with quick recoveries after cyclical shocks and low demand elasticity to rate increases.

• Ports: While ports face pressure from increasing tariffs, credit impact is limited. The average tariff rate increased from 2.2% in April to around 14% through November 2025, although impact was reduced because many importers front-loaded shipments to build inventory ahead of tariffs. The higher tariff rates will soften 2026 shipping demand, however, ports remain insulated as many are landlord ports. This limits exposure to shipment declines as their revenues come from long-term leases of container space with minimum annual revenue guarantees.

• Mass transit: Transit continues to improve with rising return-to-office requirements. Ridership rose to around 85% of pre-pandemic levels in 2025, up from 70% in 2024. However, hybrid work remains entrenched, limiting ridership growth potential. Transit funding from sponsoring governments is crucial, with a number of agencies facing funding cliffs in the coming years. States such as Illinois and New York have dedicated new funds to transit, while states like Pennsylvania have lacked the political support to do so.

Resiliency

Resiliency is strong and stable, given the critical importance of transportation assets to the nation. Traffic recovery has improved financial metrics, providing a buffer if the economy declines. Ports and mass transit face more pressure, yet credit impact is limited as mitigants are in place that insulate revenues used to pay debt service.

Utilities: Holding the Line

Outlook

Essential utilities’ strength continues into 2026 with their monopolistic authority and growing demand for services, despite reductions in federal funding for infrastructure enhancements. Operations remain strong with debt service coverage of around two times on average and liquidity exceeding a year’s worth of expenses. Risks remain as inflation has increased the cost of infrastructure investments. Water and sewer entities face higher costs for aging pipelines, compounded by climate concerns with increasing water scarcity and the growing need for water for data centers and population growth. Electric utilities continue to invest in asset hardening to withstand more frequent weather events and wildfire potential across the nation, in addition to rising power needs from data centers and population growth. The January 2025 fires in California brought wildfire risk to the forefront, as they temporarily caused spreads on Los Angeles Department of Water and Power bonds to widen.

We anticipate financial performance will continue to be strong given pricing power, with many utilities passing through rate increases to support capital investment. Risks of political pushback to rate affordability are rising, which could limit ability to increase rates. Power and water/sewer rate inflation was more than 1.50% higher than baseline inflation through September 2025.

Electric utilities face increased diversification pressure with reduction in federal grants to achieve net-zero carbon goals in addition to the rising grid demands. Renewable energy remains a focus for some electric utilities and there is rising interest in expanding nuclear power. The immediate need for increased power demands is expected to limit decommissioning of fossil fuel generation facilities and further potential new construction. Water and sewer utilities are also seeing increased demand as artificial intelligence and data centers require significant cooling capacities, leading to increased capital spending to fund infrastructure. Cybersecurity risks across the sector remain elevated as well, though utilities continue to invest in dedicated technology teams and partner with state agencies for insurance and oversight.

Resiliency

We expect the sector’s resiliency to remain strong with limited exposure to economic cyclicality, in addition to their position as a natural monopoly, with rate setting authority and solid reserves to support operating and capital needs.