2026 Municipal Sector Drivers

State Governments

Sector Outlook: Stable (maintain)

Sector Overview:

States weathered a volatile 2025 well with budgets performing better than expected and balance sheet reserves largely remaining intact. Our “Stable” outlook for 2026 reflects an expectation that a resilient economy will result in maintaining positive growth in tax revenues. While revenues are expected to be sufficient to cover expenses, the margin of safety is narrowing. Costs are rising, particularly in the areas of labor, construction, education, and healthcare, in addition to SNAP (food assistance) changes brought on by the OBBBA. 

Our outlook factors in still strong budgetary reserve balances, stable-to-improving debt burdens and pension funding, and a history of fiscally prudent management across most states. These factors can stabilize creditworthiness should the economy  slow and tax revenues underperform.

Longer-term, changes in Medicaid and diverging demographic trends will shape state budgets, but these factors are less impactful in the near-term.

Trends We’re Watching:

Stock Market and Tech Exposure

• States that levy personal income and/or capital gains taxes and have a high reliance on a wealthy cohort of taxpayers largely enjoyed strong tax revenue performance in 2025 as the equity markets rallied. Separately, but related, the boom in AI, data centers, and power demand are driving stronger economic activity in certain areas of the country. A stock market correction or a “bubble-burst” in AI would likely have a negative impact on U.S. States most exposed to these dynamics.

Disaster Costs and FEMA

• We’ve seen a reluctance at the federal level to apply the same amount of financial and human support in response to disasters than States are accustomed to. Our assumption is that States will be required to foot a larger part of the bill in the event of natural disasters, which would require greater liquidity and higher potential debt issuance. We don’t believe these risks are overly significant though, but they do reflect a change in how costs are shared, with the Fed having historically taken on the bulk of response and recovery costs.

Source: National Association of State Budget Officers, Fall 2025 Survey

Local Governments

Sector Outlook: Cautious (change from Stable)

Sector Overview:

We are downgrading our 2026 outlook for Local Governments (Cities, Counties & School Districts) to “Cautious” from “Stable” as expense pressure is expected to outweigh positive but slowing revenue growth in most cases. Local Governments are facing the same fiscal pressures as States – higher costs associated with labor, construction, K-12 education, and healthcare – but at a more acute level. As a result, we expect a greater prevalence of operating deficits and resulting draws on reserves in 2026. 

We are more favorable on Cities and Counties, as they tend to have greater budgetary flexibility, although this will vary case-by-case as some States have stringent restrictions on increasing locally sourced tax revenues. We see the most pressure in K-12 education, where labor costs are outpacing revenue growth, demographic changes are driving enrollment changes, and pandemic aid is all but gone. We expect to still be able to identify high-quality investment opportunities in the Local Government sector but will be highly selective when examining new issuers and when reviewing existing exposure.

Trends We’re Watching:

Home Prices

• Favorably, the housing market remains tight, and home prices are still considered high. This has a positive impact on property tax revenues, which are typically the largest revenue source for Local Governments. The Trump Administration is acutely focused on increasing activity in the housing sector given its importance to the overall economy. We will watch to see what policies are proposed and ultimately implemented, although we view negative developments concerning home prices as unlikely.

Public Safety Costs

• A number of large cities incurred over budget public safety costs in 2024 and 2025. This presents a conundrum, as lower crime helps attract residents and businesses but may require a larger police force, the costs of which must be funded within each entity’s revenue raising ability. A balance must be struck, and we will be monitoring this expense item in 2026, as there are both economic and budget implications for cities. 

Source: U.S. Bureau of Labor Statistics

Healthcare

Sector Outlook: Stable (maintain)

Sector Overview:

The Healthcare sector is still finding its stride after years of adapting to a challenging operating environment in the wake of the pandemic. Many headwinds such as wage growth, supplies inflation, and a challenging payer environment persist, although most hospitals are refining their operations to meet these realities.

Management teams are utilizing various strategies to enhance revenue streams. Increasing outpatient volumes remains a key focus to improve convenience and access to patients while generating a predictable and cost-effective revenue source for providers. Many systems have had success in renegotiating higher commercial insurance rates and new state-directed payment approvals will temporarily boost Medicaid funding in some States.

Labor continues to have an outsized impact on expense pressures, and supplies inflation remains elevated primarily due to pharmaceuticals and medical devices. Event risks such as cyber-attacks and environmental incidents are increasingly common, leading to an increase in defense expenses and one-time costs. Effective management teams are utilizing a variety of strategies to create efficiencies and drive down costs, characteristics we seek in evaluating issuers.

The combination of enhanced revenue streams and diligent expense management has allowed the median operating cash flow margin to reach 6.5% in FY24 as reported by Moody’s, a level that allows systems to meaningfully grow their balance sheet while investing in critical infrastructure.

Trends We’re Watching:

Federal Government Changes

• The 2025 OBBBA legislation provides time to adjust to an increase in uninsured lives and expected revenue cuts, although management must plan diligently to make these adaptations. Proposed funding cuts at the NIH could present more immediate challenges to hospitals with large research programs.

Portfolio Optimization

• While hospitals are rapidly expanding outpatient capacity, many are refining their inpatient offerings. Hospitals are focused on high acuity clinical areas to ensure optimal efficiency at inpatient facilities. In some cases, this may involve realigning service lines and portfolio assets, leading to divestiture or new partnerships. Doing so can free up capital at a time when hospitals are increasing their debt capacity, allowing for greater flexibility to optimize portfolio strategy.

Sources: Moody’s, Medians – Profitability improves as revenue grows faster than expenses, Aug 2025; S&P, U.S. Not-for-Profit Acute Health Care 2026 Outlook: Resilient For Now, With Increased Credit Risk on the Horizon, Dec 2025; S&P, U.S. Not-for-Profit Acute Health Care 2024 Median: Positive Operating Performance Resumes, Aug 2025; KaufmanHall, National Hospital Flash Report, Dec 2025; Bank of America – US Municipals Year Ahead 2026, Dec 2025

Higher Education

Sector Outlook: Stable (maintain)

Sector Overview:

We are maintaining a “Stable” outlook for the Higher Education sector for 2026. While 2025 was among the most challenging years the sector has faced, it also demonstrated its resiliency. Higher Education has increasingly become a bifurcated sector as large flagship schools with robust liquidity and student demand are continuing to perform well, while lower-tier private schools largely located in the Midwest and Northeast are struggling. This dynamic supports a stable overall sector outlook, but issuer differentiation is critical given the bifurcation.

At Appleton, we prefer Higher Education institutions that maintain a strong demand profile, operate on a large scale, benefit from revenue diversity, and have substantial financial reserves. An economic downturn could serve as a modest tailwind for the sector as historically weaker labor markets tend to support graduate enrollment growth. Similar to 2025, we prefer public institutions over private institutions.

Trends We’re Watching:

Evolving Federal Policy Environment

• The Higher Education sector was a high-profile target of the Trump Administration in 2025 as research funding was slashed at numerous institutions, DEI programs were disbanded, a new endowment tax was implemented, and accreditation agencies were challenged. Greater clarity is expected in 2026 as universities negotiate with the Administration and these issues play out in court.

Volatility and Headline Risk

• 2025 was choppy for the sector and we expect that to persist in 2026. There was plenty of headline risk last year and the volatility created dislocations that Appleton’s Portfolio Managers and Traders were able to capitalize on. We expect some of the same in 2026.

An “Enrollment Cliff” Looms

• A widely discussed “enrollment cliff” is expected to commence in Fall 2026, although for the time being enrollment trends continue to hum along. According to the National Student Clearinghouse Research Center, preliminary Fall 2025 data shows that overall enrollment grew 2.0% YoY. Undergraduate enrollment increased 2.4%, while graduate enrollment rose by 0.1%. Public 4-year schools saw 1.9% growth, while private 4-year schools only realized a 0.9% increase. From an enrollment perspective, the sector will enter a transition phase from a position of relative strength.

Sources: National Student Clearinghouse Research Center, “Preliminary Fall Enrollment Trends”, November 2025; Higher Ed Dive, “The coming decline in high school graduate counts, in 5 charts”, January 2026

Airports

Sector Outlook: Stable (maintain) 

Sector Overview:

We are maintaining our “Stable” outlook for the Airport sector, with enplanement growth muted but still positive through the first 11-months of 2025, increasing just 0.2% YoY.  Economic stability and strength among  higher-end consumers is anticipated in 2026, and this bodes well for enplanement activity. Growth in enplanement activity is expected to fall in the low single-digit range, a sufficient level to support most larger airport credits. However, an economic dynamic driven by the higher-end consumer will challenge operations at many medium and small-hub airports more reliant on budget consumers and low-cost airlines, further bifurcating the sector.

The Airport sector will also remain challenged by ever increasing capital needs, with the Airports Council of International-North America estimating total infrastructure spend at nearly $174B through 2029, up from $151B just last year. Ongoing inflation and tariff pressures will likely push this figure up, necessitating additional borrowing after a record year of issuance in 2025. Importantly, airport credit profiles remain very strong, with Moody’s projecting median days cash remaining above 700 days and debt service coverage consistently above 1.5x. Further supporting the stable credit profile of the sector are generally credit supportive airline use and lease agreements that allow airports to pass on the higher costs of projects to the signatory airlines, mitigating concerns around these large ongoing capital plans.

Trends We’re Watching:

Geopolitical Pressures

• International enplanement levels declined in FY25, due at least in part to the ongoing conflicts involving the Administration and Canadian and European leaders. Sustained pressure of this nature, including additional visa fees and enhanced vetting, could further impact international travel, continuing to challenge the enplanement recovery for those airports serving as international gateways.

Another Government Shutdown

• There is a growing possibility of another government shutdown at the end of January 2026 should an agreement on the enhanced ACA subsidies fail to be reached. Another prolonged shutdown would negatively impact enplanement growth projections for FY26 given the expected shortage of TSA and air traffic controllers, with additional stresses likely should another government-mandated curtailment of activity at some of the most active airports materialize.

Sources:  Airports Council International-North America; Airport Infrastructure Needs Study; Moody’s, “2026 Airports Outlook”, December 2025; Transportation Security Administration; S&P, “2026 U.S. Transportation Activity Estimates,” December 2025.

Public Power

Sector Outlook: Positive (change from Stable)

Sector Overview:

Early 2025 was eventful given the devastating wildfires in Los Angeles that temporarily unsettled the municipal public power market. However, the second half of the year was far more muted, and natural gas prices, a key cost driver, were largely stable. Henry Hub natural gas prices ranged between $2.8 million BTU and $5.9 per million BTU in 2025 (EIA), a notable improvement from the peak of $8.8 per million BTU reached during 2022. Last year’s stability was certainly welcomed from a credit perspective.

We are upgrading our outlook for the Public Power sector to “Positive” for 2026. Sector issuers have thus far demonstrated an ability to manage increased demand from data centers and manufacturing, and nuclear and coal are coming back into relative favor, which offers fuel diversity and operational flexibility. Federal government support through initiatives and the potential for additional deregulation further cements our outlook. At Appleton, we prefer public power providers with large scale and favorable demographic metrics, solid coverage levels, and considerable financial flexibility. After an extended period of largely flat demand, the sector is now experiencing sustained load growth, creating the need for higher capital investment. The issuers we invest in will generally be able to recover higher costs through rate adjustments. In the event of an economic downturn, the Public Power sector’s credit quality would likely be more resilient than other higher beta municipal sectors.

Trends We’re Watching:

Data Centers and Manufacturing Demand

• As AI continues to grow in prominence, data centers and public power providers will play an increasingly important role. As displayed in the accompanying chart, manufacturing companies have also bolstered their electricity demand due to onshoring efforts. To mitigate the risks to data centers, most public power providers have been requiring upfront payments, supplemental agreements, or even self-supply arrangements to limit the strain on the existing grid. We view the sector’s disciplined approach so far in managing these risks as a credit positive.

Renewed Role of Nuclear and Coal

• The federal government is supportive of nuclear power construction going forward ($900 million of federal funding was made available by the Department of Energy), especially when co-locating with data centers. Coal is back in the fold as many public power producers view the competitiveness favorably and have a desire to diversify power sources.

Affordability Pressures

• A key risk to our positive outlook is affordability. The national average retail electric rate has increased by 28% since 2022, while CPI has increased by 16% (S&P). While public power rates tend to be lower than investor-owned utilities, this could pressure affordability over time.

Sources: Energy Information Administration, “Henry Hub Natural Gas Spot Price”, December 2025; Deloitte, “2026 Power and Utilities Industry Outlook,” October 2025; S&P, “US Public Power and Electric Cooperative 2026 Outlook,” December 2025.

Toll Roads

Sector Outlook: Stable (maintain) 

Sector Overview:

We are maintaining a “Stable” outlook for the Toll Road sector, with both revenue and transactions continuing their recent positive trends. Total vehicle miles traveled nationally maintained a steady growth trajectory through the first ten months of 2025, with mean annualized growth over the last three years at +1.3%, essentially in line with the pre-pandemic growth rate of +1.1%. Similarly modest growth is expected in 2026 given our expectation of economic expansion, with toll revenue growth faring better given a widespread commitment of management to increasing toll rates, with the majority of systems benefiting from programmatic CPI-linked increases.

The sector will be challenged by increasing construction costs, due at least in part to continued tariff pricing pressure, likely necessitating additional debt issuance to fund large-scale capital plans supporting both system expansion and the sector’s substantial deferred maintenance. Importantly, recent strong results have left the sector in a very strong fiscal position, with Moody’s projecting average days cash nearing 1,400 days and median debt service coverage consistently above 2.0x. This affords systems the flexibility to spend down available liquidity and increase debt service costs without materially impacting credit quality.

Trends We’re Watching:

Material Changes to Inflation

• Elevated inflation over the last few years has allowed toll systems to raise rates well above historical averages, supporting strong revenue growth, mitigating the impacts of both a slower recovery in transactions and higher operating costs.  Should inflation moderate, revenue growth will lag given an expectation of muted growth in transactions. Conversely, elevated inflation could pose affordability concerns for those toll systems that operate in less economically vibrant regions.

Tariff-related Trade Pressure

• Commercial volumes have been resilient through this period of trade uncertainty, supporting strong revenue growth given the materially higher toll rate paid by commercial vehicles. Should trade pressures cause commercial transaction growth to slow, those systems more reliant on commercial vehicles would be challenged given cost pressures.

Sources: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Moody’s, “2026 Toll Road Outlook”, December 2025; S&P, “2026 U.S. Transportation Activity Estimates”, December 2025.

Water and Sewer

Sector Outlook: Stable (maintain)

Sector Overview:

Credit challenges are likely to soften in 2026 for the reliably defensive Water and Sewer sector. Decreased regulation is a short-term positive for public utilities, reducing regulatory-driven capital spending and operating costs. Recently rolled back policies will also support lower regulatory costs over the next few years, giving us confidence that operating margins for water and sewer utilities will improve. Regardless of regulations, this sector is capital-intensive, and we expect healthy bond issuance in 2026 as management teams rehabilitate aging infrastructure.

As the demand for water and sewer services is highly inelastic, changes in the economic cycle have only muted impacts on customer demand. Therefore, credit conditions are highly localized, and issuer specific capital utilization, rate discipline, and cost management will ultimately drive issuer  fundamentals. While all credit decisions are unique, this is particularly the case among water and sector bond issuers.

Trends We’re Watching:

Affordability Concerns

• The positive is that reduced supply chain shocks and lessened regulatory pressures should result in expenses growing at normalized levels in 2026. However, affordability has become a national buzzword, implying a heightened sensitivity to rate increases that in the past have often been afterthoughts for utility customers. Although affordability awareness has increased, water and sewer utilities provide essential services, and demand for those services is highly inelastic, a key credit attribute. We are confident that utilities that serve financially healthy customer bases will be able to fully recover costs and maintain their credit standing in 2026.

Reduced Federal Involvement

• While lower regulatory demands should lower costs and marginally scale down capital expenses, the Federal government has also historically been a supporter of the industry through low-cost loans that subsidize financing capital costs. A step back by the Federal government could be a mixed bag and would not be seen as solely a positive development.

Source: S&P, “2026 Water & Sewer Outlook,” December 2025

Mass Transit

Sector Outlook: Stable (maintain)

Sector Overview:

The Mass Transit sector continues to face depressed ridership levels, although many systems have successfully adapted to this new normal and have come to terms with the fact that ridership is unlikely to return to pre-Covid-19 levels. Federal aid acted as a crutch during the years immediately following the initial drop in ridership, thereby affording transit systems time to find new revenue sources, much of which was replaced with state and local tax dollars, a relatively stable revenue source.

Transit systems with a greater portion of revenue derived from state and local taxes are viewed by our Credit team more favorably, although increasing revenue from these sources may prove difficult in the future. State and local aid will be constrained by slower revenue growth, rising labor and capital costs, and political uncertainty. The ability of states and localities to backfill farebox losses varies greatly and is largely dependent on the health of the underlying economy each entity serves. Transit systems that are central to regional economic vitality and workforce mobility are more likely to receive sufficient support on a timely basis.

Trends We’re Watching:

Revenue Mix Shift

• Reliance on state aid, which has become increasingly necessary to account for the drop in farebox revenue, is an important credit ingredient While the essentiality of Mass Transit will necessitate sustained funding, this revenue source can be volatile given the propensity of states to reduce funding during weak economic periods.

Federal Government Involvement

• The U.S. government froze $18B of previously approved transit funding in October 2025, a policy stance that impacted many sizeable projects already underway. While most transit systems have sufficient liquidity to keep projects running, a prolonged freeze would likely compromise adherence to timelines and drive-up costs.

This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.  Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience.