Muni Credit Conditions and Higher Rate Environment

Municipal credit remains broadly resilient despite higher rates and emerging budget pressures

Current Muni Credit Conditions

Muni Credit fundamentals heading into year-end 2026 remain healthy

• Revenues are performing relatively well, supported by a resilient economy.
• Budget performance has been strong, supported by conservative expense projections.
• Strong budget performance reduces the need to tap reserves.  As a result, Rainy Day Reserves remain near all-time highs, providing future budget flexibility.
• Pensions are on a multi-year improvement trend, driven by solid investment returns and consistent contributions.

Modest Challenges Emerging

• Revenues continue to outpace expenses, but margins are narrowing.
• In some sectors and for some issuers, the margin is turning negative, such as K-12 education.
• Budget discussions are getting harder – costs for labor, healthcare and utilities are growing more rapidly.

Despite these emerging challenges, most investment grade municipal issuers are well-suited to manage the current elevated rate environment.  Robust budgetary flexibility combined with near-historic highs in reserve balances provide sufficient offsets to economic volatility. 

The Positives in Two Charts

Revenues Performing Relatively Well

• A resilient economy has supported overall revenue growth.
• We have actually seen an uptick in revenue over last 12 months, driven by solid employment, investment market performance, and sales tax revenues boosted by inflation.
• Even when other sectors face pressure, the broader municipal ecosystem tends to remain resilient because revenues are tied to essential public functions rather than purely cyclical economic activity.

Reserves Remain Strong; Ready for Revenue Normalization

• COVID drove home the need for substantial reserves, marking a structural shift in how state and local governments manage their balance sheets.
• Revenue trends have been strong, but budget officers understand they are not sustainable.  In preparation, reserves have been built for the inevitable revenue normalization.

Impact of Higher Rates

The simple equation is that higher rates result in increased borrowing costs for municipal issuers. Rates in the high-grade muni market have reset upwards by 70-105 basis points in the month of September alone. While that can make an impact on debt costs, the reality, however, is more nuanced.

We expect a pullback in issuance and have already seen a number of deals delayed.  Refunding activity is the first to be culled as higher rates reduce the present value savings, potentially eliminating any savings. Then those issuers with long-term and flexible capital planning capabilities, may defer new money projects to see if rates decline or volatility dampens, at the very least.

Even for those issuers that are moving ahead with issuance, the higher rates need to be taken into context. 10yr AAA muni yields have reached the highest levels since 2008, but this means that issuers have been in these rate environments before and have issued debt without hurting their credit profile or finding their way into distress.  Interest costs of 4-5% are higher than we’ve experienced in some time but are manageable within the scope of well-run municipal issuers.

Another aspect to consider is that most municipal issuers sell bonds at fixed rates and an elevated rate environment does not reset the costs for the entire debt stack.  For example, the State of California will issue approximately $3.6bn in new money debt in 2026.  Even if all of that was issued at a borrowing cost of 5%, the State has roughly $67bn of outstanding debt that was issued at lower rates over the past 10 years.  For most large municipal issuers, higher rates work themselves into overall debt costs over a multi-year period.

Issuers & Sectors Most At-Risk to Higher Rates

As rates increase the issuers most at-risk are the weakest ones – those with an upcoming large maturity and need to refinance, those experiencing cost overruns and need to finance additional construction, those that are highly leveraged compared to revenues, and those that are reliant on a speculative or single-site project.  High-quality municipal issuers are not immune to higher rates, but certainly have balance sheet flexibility to either wait it out, cash-fund capital expenditures, or use shorter structure debt that can possibly be refinanced at lower rates in the future.

Examples of sectors that are most sensitive to higher rates include housing, land secured and senior living.

• Housing – The impact for State and Local Housing Agencies is somewhat mixed.  Higher rates discourage homebuying, which will reduce loan originations and slow down business.  On the other hand, higher rates discourage refinancing, reducing the prepayment risk for bond investors.
• Land Secured – These are bonds that financed infrastructure for new communities, such as roads, sidewalks, and sewers.  Bonds are typically paid by homeowners, but it requires successful building and selling of the finished home lots.  A higher mortgage environment makes home purchasing more expensive, potentially slowing the development and reducing revenues available for bondholders.
• Senior Living – Some senior communities require a large upfront payment for entrance, often funded by the sale of the resident’s home.  In a tighter housing market, hampered by higher mortgage rates, some Senior Living communities may see slower fill up if potential residents can’t sell their homes at adequate prices.

Notably, Appleton’s exposure to housing is minimal and as noted above, the impacts are not overly concerning from a credit standpoint. We have also not actively participated in the land secure and senior living sectors.

Sources: Bloomberg, State of California

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