As investors consider the performance of the municipal bond market going into the fourth quarter of 2025, we believe there are many positive factors to note. Year to date through September 12, the Bloomberg Municipal Bond Index (muni index) returned 2.70%. Starting yields on municipal bonds remain attractive; the muni index yield at that date stood at 3.56%, representing a 6.0% tax-equivalent yield. Longer-dated municipal bonds (maturities of 22 years or greater) yielded 4.6%, or about 7.8% on a tax-equivalent basis. (Tax-equivalent yields based on the top 40.8% tax rate.)

Clearly, the asset class retains its appeal for investors seeking tax-free income. Against that backdrop, however, we continue to receive questions about the overall fiscal health of U.S. states, the major issuers of general obligation municipal bonds. We are also asked about the state and local governments that are among the largest individual issuers within the asset class. Here, we will address these questions and offer some observations about their implications for investors.

What is the overall status of U.S. state budgets?

With the ink freshly dry on most fiscal 2026 budgets, there is a distinct trend emerging. States are heading into the next fiscal year with reserve levels that are twice as strong as their historical average; revenue growth that has continued to beat forecasts; and the slowest rate of budgeted spending growth in more than a decade. 

The $327 billion in reserves held across all states at the end of fiscal 2025 represented 25.2% of state spending in that year, a proportion that has softened when compared to the stimulus-fueled highs of the pandemic period, but that remains materially above the long-term average of 9.6% seen since 1979. State revenues collectively beat budgets by 2.2% in 2025, the fifth consecutive year of revenue outperformance, and yet 24 states are budgeting to spend less in 2026 than they had in 2025. In aggregate, states are budgeting for 2026 spending to be just 0.8% higher than 2025, the smallest annual increase since 2010.¹

How have trends in U.S. state finances played out for major municipal bond issuers?

California, which last year overtook Japan as the world’s fourth largest economy, reported 2025 revenues that were about $5 billion (2.4%) ahead of budget and enacted a 2026 budget that cuts spending by $5.2 billion from 2025 levels. Cash reserves remain at historically strong levels; the latest monthly disclosure shows the state holding just over $41 billion, roughly 18% of annual expenditures, near the highest percentage of the past three decades. The state has positioned itself for continued fiscal stability through its use of conservative revenue and economic assumptions when drawing up the 2026 budget—for example, the state’s estimate for fiscal 2026 capital gains tax revenue is based on their assumption that the S&P 500^® Index will fall to 5,388—a figure nearly 19% below the index level in mid-September—by the end of 2025.²

Illinois reported a record-high $54 billion in revenue in 2025, beating budget by over $700 million. The state’s present strength is a reflection and continuation of the positive trends that have garnered nine collective upgrades from Moody’s, S&P, and Fitch over the last five years. Despite projections early in the 2026 budget process warning that the state could face shortfalls of up to $3.2 billion, lawmakers were able to enact a budget this summer that instead projects a $217 million surplus without relying on broad-based tax hikes or overly optimistic revenue assumptions. The 2026 budget also allocates over $10.5 billion toward pension contributions, furthering the progress Illinois has made over the past several years.

In Chicago, though budget negotiations remain contentious, solid economic fundamentals and readily available revenue-raising levers provide a path toward structural balance and financial stability. The Chicago metro area’s gross economic output of roughly $900 billion trails only New York City and Los Angeles. Chicago area employment is also among the nation’s most diverse. Revenues are trending well above budget through June, except sales taxes, which are a small component of total corporate fund receipts. Moving forward, the city has several options at its disposal to manage an estimated $1.1 billion 2026 budget gap. While property tax increases will be the most politically challenging, we believe other city-wide surcharges are more easily adoptable. Like its home State, Chicago has made considerable progress on pension funding. To be sure, pension liabilities and budget tensions present challenges for Mayor Johnson, though we believe Chicago remains well positioned to navigate this uncertainty.

New York has remained on a strong financial footing even as its budgets have continued to grow. The state reported a $10.6 billion surplus in fiscal 2025 that grew reserves to $38.7 billion. The windfall in recent years has allowed the state to cut taxes on the lowest brackets and provide a $2 billion tax refund to qualified New Yorkers. While the 2026 budget bucks the nationwide trend by boosting spending 11% versus 2025, most of that growth is from one-time expenses and remains structurally balanced outside of these extraordinary items.

New York City reported a preliminary $3.2 billion surplus in fiscal 2025, boosting reserves to $6.9 billion. While political uncertainty will remain a highly publicized source of credit risk for the city, past concerns have tended to prove exaggerated in hindsight. For example, the spending pressures posed by the surge in asylum seekers certainly cost the city money, but fiscal 2025 spending for these purposes ultimately landed $1.5 billion below what had been budgeted. Uncertainty over the fiscal impact of campaign promises made by mayoral candidate Zohran Mamdani has generated a lot of media coverage, but in practice, his proposals will require the input, cooperation, and approval of the state, various local agencies, and fiscal watchdogs, which we believe limit the potential fiscal stress arising from these proposals.

New Jersey credit quality continues to trend upward, as evidenced by recent ratings upgrades from S&P and Moody’s. The state heads into fiscal 2026 with $8.3 billion in reserves (14% of budgeted 2026 expenditures) compared to the $400 million held going into the pandemic. While lawmakers are budgeting for reserves to soften in fiscal 2026 as they spend down a portion of this windfall, we believe the state’s commitment to future financial stability is made clear by its spending priorities: reducing debt, making pension contributions, providing tax relief, and investing in transportation infrastructure.

Massachusetts posted a $2.4 billion budget surplus in fiscal 2024, growing reserves to $15 billion, an exceptionally strong 29% of expenses. Preliminary figures for fiscal 2025 show revenues $2 billion (5%) ahead of projections. The state’s economy is centered around high-wage jobs in education/research, healthcare, and technology, and its spending priorities reflect a desire to remain competitive in these fields. Lawmakers passed a $4 billion Economic Development Bill in November 2024 to fund projects across high-value-add sectors like life science, clean energy, and artificial intelligence (AI). Longer term, the state aims to address affordability and outmigration concerns through measures such as encouraging housing development close to mass transit stations.

A Final Word

While the credit trends detailed here remain positive, we continue to watch for any early indicators of potential weakness. Unexpected declines in tax revenue or other downward budget revisions may signal a softening in a state’s underlying economic activity. Many states publish monthly revenue updates that provide municipal investors with timely snapshots of fiscal performance before they show up in annual financial reports or even in economic indicators.

Meanwhile, market dynamics continue to point to compelling relative value in municipals, with the 10-30 year spread in the muni index at the steepest level seen since 2013. The strength of municipal credit, including the improving fiscal standing of key issuers detailed here, and the steepness in the yield curve offer investors in municipal securities the opportunity to lock in attractive tax-free yields on very high-quality bonds.