2025 Municipal Bond Sector Outlook: Stability and Resiliency

_{Source: Northern Trust Asset Management}

State and Local Government: Back to Basics

Outlook

We maintain a stable outlook for state and local governments, including school districts. We expect tax revenues to remain positive in 2025, though growing at a slower pace than in recent years as the economy cools.

After three years of operating growth fueled by federal funding during the pandemic, governments now face mounting pressures, despite having significant reserves and improved pension funding stability. In 2025, we will focus on sustainable operations post-stimulus and monitoring potential federal policy changes that could impact state and local finances. For example, a change to expanded Medicaid provisions under the ACA could leave states with an estimated combined $50 billion gap to fill.

Other key issues include:

• States: Twenty-seven states have enacted income, sales, or corporate tax cuts since 2021. Combined with moderating inflation, the cuts have contributed to slowing tax collections, although national averages growth is in line with historical averages. For example, West Virginia passed legislation in 2023 to cut the income tax rate, which contributed to a projected 16% decline in income tax receipts in 2024.
  
• Local governments: The sharp rise in home prices along with stabilizing commercial real estate values have supported local government property tax revenues, although home price increases have heightened tensions over affordability.
  
• School districts: Enrollment declines, which can reduce state funding, can put school districts under greater pressure than other levels of government. Total public school enrollment is projected to decline by more than 5% from 2022 to 2031, due to changing demographics and the increasing prevalence of school choice programs. Federal policy changes, such as a reduction in grant programs, could introduce additional risks to this sector.

Resiliency

The sector’s reserves remain a key resiliency factor, with the National Association of State Budget Officer’s reporting state rainy day fund medians at nearly 14% of expenses for 2024, which are above the pre-pandemic levels of around 8%. We expect these reserves may modestly fall as pandemic aid is spent, but the large reserves will help to support resiliency in 2025 and beyond. State and local governments are also resilient by nature and have the ability to raise revenues and cut spending in the event of weak fiscal performance. We also continue to monitor the potential impacts of climate change as the number of annual billion-dollar disasters rises, remaining alert for any changes to federal disaster policies.

EXHIBIT 2: REVENUE VOLATILITY SUBSIDES

Growth in tax revenue returned to trend in 2024 and we expect positive growth in 2025.

_{Source: Northern Trust Asset Management, U.S. Census Bureau. Data as of September 2024.}

Higher Education: Mixed Views

Outlook

We have a mixed outlook on higher education, with a stable outlook on public higher education and large private institutions, but a negative outlook on small (below 3,000 enrollment) and moderate (3,000 to 10,000 enrollment) private institutions. Public higher education has stabilized, supported by state appropriations in recent years, improved enrollment trends, and margins that now exceed pre-pandemic levels. Large private institutions, typically highly rated with strong brand recognition, are bolstered by strong endowment gains and pricing power, advantages that smaller colleges often lack.

Average operating margins at small private institutions have slipped to negative, with enrollment facing challenges from shifting demographics and changing consumer preferences. A disproportionate number of small- and mid-sized private institutions are located in the Northeast and Midwest, regions facing the largest demographic challenges. We are increasingly selective in choosing higher education bonds rated approximately A and below. We are also watching policy developments, as higher education may find itself in the crosshairs of the new federal leadership. Some Republicans, for example, have called for raising and expanding the tax on university endowments.

Issuance in the sector is up 93% in 2024 (through November) over 2023, although it is still below record levels set in 2008. We anticipate another strong year for issuance in 2025, driven by pent-up capital needs, as reflected in the rising age of plant metrics and the pressure on universities to remain competitive. A potential threat from Congress to universities’ ability to issue tax-exempt bonds could result in a surge in issuance.

Resiliency

Net tuition growth expected to lag behind inflation constrains the sector’s resilience. Record-high discount rates limit pricing flexibility, while shifts in higher education demand pose longer-term challenges. These pressures are partly offset by balance sheet improvements that enhance liquidity, particularly for well-known private institutions and flagship public universities.

EXHIBIT 3: OPERATING MARGINS DECLINE

As pandemic aid ran off, public college margins declined back to trend, but private colleges, particularly small ones, fell below pre-pandemic levels.

_{Source: Northern Trust Asset Management and Merritt Research Services as of fiscal year 2023.}

Healthcare: Policy Uncertainty

Outlook

The fundamentals of the not-for-profit (NFP) healthcare sector remain supportive, but the sector is entering a period of increased policy uncertainty. Fiscal 2024 has been a year of recovery for providers, continuing a dynamic that began in fiscal 2023.

COVID-era inflation and wage pressures have broadly reset the long-term cost basis for providers. However, ongoing recovery, normalizing labor markets, and a heightened focus on revenue cycle and expenses management signal a more constructive credit environment. The pace of recovery has been uneven across providers. Issuers who experienced more acute operating/financial pressure through the pandemic and/or had pre-existing challenges continue to lag in the transition to recovery.

Major policy disrupters reside at opposite ends of the political spectrum and are generally thought of as Medicare-for-All on the left and a Repeal-and-Replace of the ACA on the right. Each would have negative implications for provider reimbursement. The ACA has survived several trips to the U.S. Supreme Court over its 14-year period and congressional repeal efforts nearly succeeded during the first Trump Administration in 2017. The incoming administration has yet to unveil a Trump 2.0 healthcare agenda, and little clarity was provided on the campaign trail. However, President-elect Donald J. Trump has consistently emphasized the unaffordability of healthcare costs. The House Speaker has signaled that major changes are on the horizon, and Cabinet nominees suggest that federal spending cuts may be under consideration.

While the new Trump Administration may have moved away from its previous tagline for healthcare reform, we anticipate that any significant changes will likely resemble earlier proposals. Republican control of Congress adds to the overall uncertainty. We anticipate the immediate focus to center on allowing enhanced Medicaid subsidies to expire, renewing Medicaid work requirements, and/or establishing a block grant funding formula, and implementing supportive measures for drug price negotiations and Medicare Advantage programs. We do not expect an immediate financial impact to providers, as the effects are likely to unfold gradually over a longer period as adjustments are implemented. This would provide more nimble management teams the opportunity to minimize the impact of policy changes.

Resiliency

We continue to view the NFP healthcare sector as a resilient area of the municipal market. Providers have a long history of responding to policy changes and have broadly survived (with federal support) the stress of the COVID-19 pandemic. Credit stress does not equate to distress, making this sector a particularly attractive relative value opportunity for municipal investors. Sector returns have generally outperformed the broader municipal market over the past 10 years.

EXHIBIT 4: HOSPITAL RETURNS GENERALLY OUTPERFORM THE BROAD MARKET

The hospital sector has outperformed the broader municipal market in all but one of the last 10 years.

_{Source: Northern Trust Asset Management and Bloomberg. Chart data is 12/31/2014 through 11/29/2024 and includes Bloomberg Municipal Index and Bloomberg Municipal Hospital Index.}

Transportation: Stable Outlook

Outlook

Our outlook for the transportation sector is stable for 2025. This is underpinned by our economic view of a soft landing. Economic growth and passenger traffic largely correlates and we expect travel volumes to track roughly in line with GDP growth in 2025 after the volatility of the past few years. Policy risks for transportation are muted compared to other sectors and the downside risks are more tied to economic growth. Toll roads have historically weathered downturns better than airports as driving miles are less sensitive to economic changes.

Airports and toll roads have benefited from improved financials, highlighted by a 30% increase in days cash on hand over the past five years, reaching near all-time highs alongside reduced leverage. Bond issuance has been depressed in recent years as COVID-related uncertainty deferred capital plans and federal stimulus addressed some needs. This is reflected by new money issuance down 9% for airports and down 19% for toll roads over the past five years compared to the previous five-year period. We expect bond issuance to increase in 2025 as capital plans expand with rising travel demand, stimulus funds are depleted, and inflation drives up project costs. We think airports and toll roads are well positioned to manage the increased debt given their improved financial position.

Ports could be pressured depending on the magnitude of tariffs implemented that could reduce imports. Mass transit ridership is growing but is unlikely to fully recover to pre-COVID levels in the near-term. Most mass transit systems rely on local funding sources such as sales taxes, which are tied to economic growth. These sources will be needed to offset declines in farebox revenues.

Resiliency

We believe the sector’s resiliency is solid, given the critical importance of transportation assets to the nation. Strong financial performance has boosted liquidity metrics to near all-time highs, which provides a buffer if the economy declines more than we expect. This cushion will protect credit quality as capital plans increase debt levels.

EXHIBIT 5: PASSENGER VOLUMES NORMALIZING

Road and airline travel have returned to pre-COVID levels and are expected to align with economic growth trends in 2025 while mass transit lags.

_{Source: Northern Trust Asset Management, Federal Highway Administration, Federal Aviation Administration, Federal Transit Administration, vehicle and mass transit data as of October 2024, airline data as of August 2024.}

Essential Utilities: Stable and Highly Resilient

Outlook

Essential utilities remain well-positioned into 2025 with their monopolistic authority, growing demand for services, and continued federal funding supporting infrastructure investments. Operations remain strong with net revenues covering debt service by around two times on average with liquidity exceeding a year’s expenses. We anticipate financial performance to remain strong in 2025 given pricing power, although risks remain if inflation reignites or an economic downturn limits ability to increase rates. Cybersecurity remains a risk, although utilities continue to invest in dedicated technology teams and partner with state agencies for insurance and oversight.

We expect debt issuance to grow next year due to rising capital needs. Water/sewer entities face shortened deadlines to replace lead piping and reduce discharge of harmful chemicals, although the new federal administration may relax these requirements. Electric utilities face a continued focus on decarbonization and asset hardening to withstand more frequent extreme weather events. New artificial intelligence (AI) and data centers are increasing power demand, and so it is essential for utilities to build new facilities and utilize excess power capacity from current power plants.

Resiliency

We expect the sector’s resilience to remain strong, given its limited exposure to economic cyclicality, its status as a natural monopoly with rate setting authority, and its solid reserves to support operational costs and capital needs. The utility sector is also less vulnerable to federal policy changes than other sectors.

Housing: Steady and Resilient

Outlook

State Housing Finance Agencies (HFAs) sell bonds to finance subsidized mortgages to targeted populations and to promote home ownership. HFA credit quality is expected to remain steady and strong in 2025. Median margins have eased from nearly 20% in 2023 to the likely 16 to 18% range in 2025 as interest rates fall, but they remain healthy and have ample cushion. High demand for affordable housing continues to benefit HFAs and we expect strong supply trends for 2025 given HFAs competitive advantage in rates to conventional lenders.

Resiliency

Resiliency remains strong. Compared to previous eras, HFAs are better equipped with strong collateralization, an increased percentage of government-backed loans, and a reduced complexity of bond structures, which will help the sector to withstand a considerable level of housing market volatility. A significant amount of cash and investments held by agencies (median: nearly 50% of bonds outstanding) will provide healthy support during economic downturns.