Municipals
TheCascadingEffectsofMedicaidCutsonMunicipalCredits
5 mins
In early April, the concurrent budget resolution for 2025-20261 was amended by the U.S. Senate and adopted by the U.S. House of Representatives (the House). The Resolution seeks to offset costs associated with President Trump’s legislative priorities. Specifically, $2 trillion in spending cuts would need to be identified by House subcommittees during the budget reconciliation process. The primary program targeted is Medicaid, the joint federal and state program that funds healthcare for 72 million lower income and disabled Americans.2 For states, Medicaid is their largest expenditure item, comprising ~30% of total spending.3
Material reductions to federal Medicaid funding are likely to trigger difficult state budget decisions, which could have considerable downstream effects on municipal bond issuers – including universities, hospitals, and local governments. With this in mind, our Municipal Bond Team maintains an up-in-quality position in sectors with high direct or indirect exposure to Medicaid cuts. We present details supporting this active positioning below.
The Bottom Line: Medicaid Spending Reductions
The Medicaid program is jointly funded by the federal and state governments, with the federal share based on a sliding scale that is determined by state per capita income levels. This share, known as the Federal Medical Assistance Percentage (FMAP), is an open-ended funding match that ranges from a minimum of 50% to 77%.
Under budget reconciliation, the Energy & Commerce Committee (a subcommittee of the House) has been tasked with finding $880 billion in cuts over the next 10 years. This is equivalent to a 10% annual reduction in spending on federal health programs over the same period. Given its jurisdiction, the Committee is likely to seek the bulk of these cuts from the Medicaid program. Various proposals are being considered to achieve the targeted reductions. Below, Figure 1 helps to illustrate the magnitude of potential savings for the most viable cost-cutting measures to Medicaid that are under consideration. Of course, Congress may choose to employ a combination of approaches or find added savings beyond those shown below.
Figure 1
Magnitude of potential cost savings over 10-years
KFF and PGIM Fixed Income.
The replacement of the FMAP with either a fixed dollar amount (block grant) or fixed amount per enrollee (per capita cap) are ideas that have been debated in the past and are still periodically mentioned as a potential means of reducing federal spending. While not our base case expectation, it is worth noting that among the various policies proposed a block grant scenario would be the most deleterious from a state credit perspective. This is due to the counter-cyclical nature of Medicaid spending – i.e., costs rise with increased participation during economic downturns. As such, Medicaid spending can be heavy draws on state revenue— which is cyclical in nature, as it historically declines during economic slumps.
Difficult Decision-Making at the State-Level
Unlike the federal government, states are required to enact balanced budgets. In recent years, flush with strong reserves from federal COVID assistance and healthy economic performance, states have been cutting taxes. In fact, 28 states have reduced taxes in the last two years, and in some cases these cuts are still being phased in. These states may face acute budget pressure in the coming year, as the cuts take effect and economic growth slows.
Figure 2
Total state expenditure by function ($ billion, %)
2024 State Expenditure Report (NASBO)
Cuts to federal Medicaid funds will only make the budget harder to balance. Figure 2 (above) illustrates the breadth of state spending, with Medicaid representing the largest share.
Fortunately, states have significant flexibility in relation to Medicaid services provided and the basis on which they are administered. We expect states to trim Medicaid spending where possible. For example, nine states have trigger rules that would unwind Medicaid expansion if the enhanced federal FMAP were eliminated (see the box, “A Proposal in Action”).
However, states are more likely to look to other areas of the budget to offset federal Medicaid cuts. Indeed, a state’s ability to push their budget pain down to underlying entities is one of the reasons they generally maintain very strong credit quality. Therefore, while states may be pressured by federal Medicaid funding declines, we expect state credit quality overall to remain sound.
A Proposal in Action
Roll-Back Effects
The potential roll-back of the FMAP for the ACA expansion population (from 90% to the state’s base FMAP level) is relatively straightforward to analyze.
The state spending necessary to cover the potential loss of the enhanced FMAP would equate to 7% of own-source governmental revenue on average; however, this share ranges from a low of 0.1% (South Dakota) to nearly 18% (Kentucky, Louisiana), according to KFF data (2023) related to the funding of benefits for the ACA expansion population.
In contrast to the potential decisions that most states would need to make to backfill lost federal funds, nine states (AR, AZ, IL, IN, MT, NC, NH, UT, and VA) built the elimination of the expansion in the event of federal funding declines into their expansion legislation. We expect these states would quickly offset lost funding by undoing their Medicaid expansions, causing three million current enrollees to lose coverage.
Credit Implications of Reduced Federal Medicaid Funding
In our portfolios, we have maintained an up-in-quality basis in the sectors below.
Local Government
K-12 education represents the second largest expenditure item (refer to Figure 2) of a state budget. While school funding is the most politically unpalatable area to find budget savings, states may seek to offset a portion of federal funding cuts by passing on the reductions to school districts.
Higher Education
The higher education sector has been challenged by prevailing secular trends – e.g., deteriorating demographics, higher tuition discounting, and greater reliance on endowment income (although investment earnings are poised to decline). During periods of budget pressure, public universities are often targeted by state legislators for funding cuts.
State budget cuts would exacerbate the pressure building in the higher education sector from other policies emanating from the White House and Congress, such as funding cuts to the National Institute of Health (NIH) and potentially higher endowment taxes. Furthermore, universities receive a large portion of their revenue from their healthcare systems. This makes them doubly exposed to potential White House policies (See Healthcare Providers section below).
We favor higher education institutions which demonstrate pricing power through strong enrollment trends and low tuition discounting, supporting healthy operating margins and liquidity. We also view a diverse revenue composition as a key buffer against operating risks.
Healthcare Providers
The current environment for hospitals has become more challenging with the overhang of possible federal changes in reimbursement. Therefore, hospitals that depend on Medicaid, along with other supplemental funding, are most at risk. Furthermore, these not-for-profit healthcare providers would be directly impacted by changes to Medicaid benefits and/or eligibility. To the extent uninsurance rates rise, we would expect providers to face greater operating pressure. This is because non-performing debt in the form of unpaid patient bills would now be borne by providers.
As a result, we have become increasingly cautious of the following hospital segments: safety-net hospitals which serve a high percentage of Medicaid patients; rural providers which also have elevated levels of lower-income patients; and to a lesser extent, children’s hospitals and academic medical centers – both of which have elevated exposure to Medicaid. That stated, children’s hospitals and most academic medical centers typically have very strong operations and balance sheets, aided by philanthropy, which helps mitigate the impact of possible changes.
Valuations in this sector have become rich over the course of the past year which, in concert with possible pending Medicaid cuts, has contributed to our decision to reduce exposure to lower-quality names. (See Figure 3.)
Figure 3
1-15 Year NFP Healthcare vs. Bloomberg Intermediate Municipal Bond Index
As of April 15, 2025. Bloomberg and PGIM Fixed Income.
Conclusion
While there is uncertainty surrounding the scope, design, and timing of Medicaid cuts, material changes to the Medicaid program are likely. Funding cuts will directly impact states, given the significance of Medicaid to state budgets. While states may bear some of the budget pain, we expect they will push funding cuts down to lower entities, some of which are already weakened due to federal policies and/or economic trends. To address this dynamic in the portfolios we manage, PGIM Fixed Income’s Municipal Bond Team has maintained an up-in-quality credit bias in the healthcare and higher education sectors. Moreover, we continue to be vigilant, looking for both pitfalls and opportunities in developments from both the federal and state budget resolution process.
1 H.Con.Res.14, a resolution to establish the congressional budget for the United States Government for fiscal year 2025 and setting forth the appropriate budgetary levels for fiscal years 2026 through 2034.
2 Medicaid eligibility is based on a percentage of the federal poverty level (FPL). The exact percentage varies by state and household size. In 2024, the FPL was $15,060 for a single person in the continental United States. For each additional person in the household, the FPL increases by $5,380.
3 Source: 2024 State Expenditure Report (NASBO).
