Muni issuers are generally sound, so cuts in aid would be felt but dealt with.
Federal proposals to cut aid to state and local governments have many municipal bond investors questioning the potential consequences. Muni issuers—especially those already under credit stress—would likely feel gaps in federal funding to some degree. But we believe that muni issuers are adept at responding to such headwinds, given their budgetary flexibility and ample reserves.
Muni Bonds and Federal Aid: Cities and States
The size and scope of proposed cuts remain unclear, but the call for them shows a paradigm shift in addressing the growing US deficit. We expect a large portion of federal cuts to target aid that states ultimately pass on to other entities, such as hospitals and school districts. However, states will likely adjust by cutting spending and raising revenues.
California—In our analysis, funding cuts would most harm public healthcare, since about 80% of the Golden State’s federal funds goes to health and human services programs such as Medi-Cal. We don’t foresee the federal government selectively reducing the state’s Medicaid funding without similar cuts nationwide. If cuts occur, we believe California can cover the shortfall by tapping its record budget reserves, reducing coverage levels or both.
In our view, California’s high tax rates continue to make its muni bonds attractive to both high-earner residents and nationally diversified investors.
City and County of Los Angeles—Federal aid received by the city and county is primarily earmarked for Medicaid, Medicare and welfare programs. We anticipate both the city and county would respond to reduced aid by cutting services to recipients. Moreover, both retain strong reserves and budgetary flexibility to adapt to funding changes.
We favor investment in Los Angeles muni bonds based on the same economic diversity and fiscal strengths that we like about California’s. And while the LA wildfires tragedy stirred up political discourse over federal disaster relief, we believe FEMA reimbursements will eventually kick in.
New York State and City—We similarly believe that New York State and City are well-positioned to withstand federal aid cuts. Much of their federal aid is directly passed through to recipients of mandated programs, such as Medicaid. So any reductions would necessarily coincide with reduced provisions of those services or a requirement to raise program funds through increased taxes or other locally generated revenues. New York State and City are also sitting on nearly $30 billion in combined budget reserves that can help to weather a storm.
We think New York municipal bonds remain a prudent tax-advantaged choice for nationally diversified muni investors and New York residents especially. We also like Metropolitan Transportation Authority bonds, believing the impact to the agency’s credit quality would be minimal if the Department of Transportation successfully terminates its new “congestion pricing” program, which is unlikely in our view. Mass transit is too essential to the region’s economy for the state not to lend support if funding losses create systemwide disruptions.
Illinois/Chicago—Federal aid rollbacks could intensify long-festering budget concerns, since the state and city rely heavily on US funds for essential services. Illinois’ fiscal health has improved, but its pension system remains stressed. We think Chicago’s tight budget would reel further if administration proposals are implemented that would channel funds to communities with “marriage and birth rates above the national average”—in practicality, away from larger cities.
Broadly, cuts in federal funding probably won’t have a significant negative effect on either issuer’s muni bonds, in our analysis. We think Illinois remains credit-challenged but is improving, and our focus is on the long haul rather than near-term liquidity. We view Chicago less favorably, as leadership manages the day-to-day effectively but appears to be neglecting long-term structural issues.
Muni Bonds and Federal Aid: Sectors at Risk
Some sectors of the $4 trillion muni market—such as healthcare and education—could be more susceptible to cuts, though our assessment suggests the effects should be manageable without causing significant credit-rating volatility.
Healthcare/Hospitals—Cuts in federal Medicaid reimbursements would create a headwind for this sector. Federal dollars account for up to two-thirds of state-level Medicaid spending. We expect a gradual $880 billion cut over the next 10 years. While this represents a sizable 10% reduction in federal Medicaid expenditures, a phase-in approach should give hospitals the opportunity to adapt.
Higher-quality names and those with less exposure to Medicaid funding will likely be less affected, in our view. We remain selective when investing in lower-rated issuers, looking for credits with sufficient budget flexibility to absorb potential reductions in reimbursement rates.
Higher Education—We think the risks to higher education are elevated in the current political environment. The administration appears determined to target large private institutions, possibly removing their tax-exempt status while hiking the current 1.4% endowment tax to the 21% corporate level.
However, these new policies may be restricted to elite, private institutions. And a potential tax-exemption elimination would apply to new issues only. A higher endowment tax would sting initially, but we think large schools have the resources to withstand it without credit-quality implications.
Senior Living—Our outlook for the senior living sector is favorable, though select issuers may be negatively impacted by lower federal funding. The greatest disruptions would stem from funding reductions to Medicare and Medicaid. But senior citizens are a major voting demographic, and policies that hurt them are usually considered politically risky.
For many reasons, we continue to prefer larger communities that provide a comprehensive range of services, such as independent living and memory care. Most of their revenue comes from charges paid out of pocket by independent living residents, so cuts in Medicaid reimbursements can be offset by raising those fees. By contrast, we remain cautious toward issuers that depend on skilled nursing facilities, which can have a high proportion of Medicaid patients and thus potentially lower reimbursement rates and profit margins.
Munis Should Hold Fast Amid Funding Cuts
Despite attention-grabbing headlines, we believe most municipal bonds will be materially unaffected by the day-to-day federal funding decisions of the executive branch.
In addition to the executive branch not having unilateral power to implement cuts, credit quality among municipal issuers remains strong. Most municipalities continue to operate in the black—many with record-high reserves and layers of budget flexibility to lean on. Some sectors face more headwinds than others, but muni issuers have historically adapted well to changes in federal and state funding levels.
Add to this the continued demand from investors seeking tax-exempt income, and we’re optimistic about the resilience of the muni market in the face of potential federal funding cuts.
