The Trump administration’s policies are having far-reaching effects on stock and bond markets worldwide. This month, we turn to Senior Vice President and Fixed Income Manager Chris Keith to share his perspective on what might happen in the municipal bond market as the federal government cuts funding for state-run programs nationwide.

In my home state of Massachusetts, there’s an ideological battle brewing between Harvard University and President Trump’s administration, with a lot of financial funding on the line. I believe Harvard, with its prestige, image and stature, will survive this battle no matter what the outcome. Of course, Harvard’s $50 billion endowment helps even if there are some restrictions on how it may be used. But what about state and local governments that don’t enjoy the same resources—how will they fare in the age of reduced federal funding?

The Triple Challenge Facing State and Local Governments

In my opinion, state and local governments may be facing a three-pronged challenge: a moderating economy, COVID-19 relief funds drying up and now reduced federal aid and spending cuts. Estimates suggest that federal aid to state and local governments last year was over $1 trillion and was applied to health care needs, education, and street and highway projects, among other uses.

In an environment where news changes quickly, predicting how reductions in federal funding and state and local government support ends is a difficult task, but it’s something we’re preparing for at RWA.

What Are Municipal Bonds?

Before discussing the implications, let’s clarify what municipal bonds are. Municipal bonds (or “munis”) are debt securities issued by state and local governments to finance public projects such as schools, highways, water systems and other infrastructure. When you purchase a municipal bond, you’re essentially lending money to the issuing government entity, which promises to pay you interest (typically semiannually) and return your principal at maturity.

Why Consider Municipal Bonds?

Investors are often attracted to municipal bonds for several compelling reasons:

• Tax advantages: Interest income from many municipal bonds is exempt from federal income tax and, in some cases, from state and local taxes for residents of the issuing state.
• Lower default risk: Historically, municipal bonds have shown significantly lower default rates than corporate bonds with similar ratings—from 1970 through 2023, munis defaulted at a rate of 0.1% compared with 2.2% for corporates, according to Moody’s and AllianceBernstein.
• Portfolio diversification: Municipal bonds provide exposure to different economic drivers than corporate or Treasury bonds, helping to reduce overall portfolio risk.
• Community impact: Your investment directly supports essential public services and infrastructure in communities across America.

The Changing Fiscal Landscape

The days of budget excesses (surpluses) appear over as COVID-19 relief funds fade. With pandemic funds gone, diminishing federal aid, and an economy expected to downshift, many state and local governments will be required to tighten their fiscal belts. This likely means a combination of spending less and reducing services. While the causes are different this time, we’ve invested through this type of “lean years” environment before: Expect to see an increase in negative news headlines about city and state budgets (the headlines will probably be worse than the actual news) accompanied by warnings and credit rating downgrades. But I don’t expect a dramatic increase in municipal issuer defaults.

Revenue Generation Will Continue

We know municipalities will have a need for capital no matter what the cost because they always do, if for no other reason than just to keep up with maintenance projects. Companies typically need to sell a product to raise revenue, but state and local governments raise revenue through taxation and user fees. It won’t be quick, easy or popular, but state and local governments will use the tools they have to raise the revenue they need to finance operations and keep a balanced budget.

States like mine impose income and sales taxes for their primary source of revenue. Tax hikes and service cuts will be applied in tandem when revenue dips. My state also maintains a “rainy day” fund estimated at more than $8 billion, though it has been reluctant to tap into it.

At the local level, property owners pay for schools, salaries, buildings, services and municipal equipment through their ad valorem (assessed on value) property taxes, while projects such as water, sewer and utilities will be predominantly paid for by user fees. We sympathize with tax and rate payers, but these typically are not optional expenses, and the gap between revenue and expenses must be closed.

What Happens Next: Our Outlook and Strategy

As federal support diminishes, here are four things we expect to unfold in the municipal bond market:

1. Short-term volatility: Municipal bond prices may experience downward pressure as negative headlines emerge about budget challenges. This could create temporary buying opportunities for strategic investors.
2. Credit quality divergence: We anticipate growing quality differences between municipalities based on their fiscal discipline, revenue diversity and reserve levels. States and localities with strong management and diverse economies will likely weather the storm better than those heavily dependent on federal aid.
3. Higher yields: New bond issues will likely need to offer more attractive yields to entice investors, particularly in jurisdictions facing greater fiscal challenges. This creates potential opportunities for income-focused investors.
4. Importance of sector selectivity: Essential service providers (water, sewer, power) will generally maintain more stable revenue streams than those dependent on discretionary spending or tourism.

When this happens, muni investors need to be prepared for the negative headlines and recognize that existing bonds may see their prices decline in response.

The Opportunity Ahead

But there’s also an opportunity both to help and to benefit. Investing in new projects is how individuals and institutions can lend assistance, and newer bonds added to portfolios and funds may carry higher yields (when bond prices fall, yields rise). Of course, investing in this environment will require a bit more research and understanding of which areas to favor and which to avoid. It may also require additional efforts to diversify your holdings within the asset class even though munis have a historically low default rate.

Our approach at RWA will focus on:

• Emphasizing high-quality issuers with strong revenue-generating capabilities
• Diversifying across multiple states and sectors to reduce concentration risk
• Maintaining appropriate liquidity to capitalize on market dislocations
• Conducting enhanced credit analysis to identify resilient municipalities

So, while reduced federal aid is likely to be a trend over the next few years, it does not mean a calamity is coming for muni bond investors. With careful selection and proper diversification, municipal bonds can continue to play an important role in investment portfolios—potentially offering even more attractive entry points for investors in the coming months.

For more information on how RWA approaches municipal bond investing or to discuss whether a muni bond portfolio is right for you, please contact your advisor.