Is K-12 still making the grade for muni investors as pressures rise?

The K-12 sector has enjoyed a strong history of full and timely repayment of debt service, as it represents an essential purpose investment suitable for the most quality-centric portfolios. School district bonds have been defined by ample state support in fulfilling its role of providing safe and secure delivery of public academic standards. The sector has received heavy voter support for bond authorizations and remained well-insulated from recessionary pressure.

The COVID era ushered in a wave of federal stimulus money that hit municipal balance sheets with unprecedented circumstances. These funds, largely derived from emergency appropriations, provided budgetary flexibility across most public finance sectors. For many pre-COVID fiscally and operationally challenged issuers, these resources proved to be the lifeblood of credit survival.

The depletion of this federal support combined with shifting governmental funding priorities have lifted the stimulus veil, exposing the K-12 sector to fundamental credit pressure with the increased likelihood of downward rating actions. Broad-based expense reduction initiatives include layoffs, hiring freezes and program curtailment.

Labor and vendor contracts are being scrutinized for ways to lower costs and alleviate fiscal pressure. Underutilized facilities are creating a financial drag for certain school districts, but many experience heavy political resistance to actual closure. Under certain circumstances, a dormant facility may be converted to an alternative school or an administrative satellite.

While the K-12 sector should not be overlooked as a portfolio diversifier and a source of credit strength, negative undertones require a careful examination of existing holdings, and local school district issuers along with financing team members are encouraged to strengthen the quality and transparency of primary and secondary market disclosure.

In my 2026 municipal bond market outlook, I identified the K-12 sector as an area poised to experience visible credit stress. While I do not envision wholesale credit erosion across the sector, not all school districts will have the managerial, operational and financial wherewithal to adapt to the evolving credit landscape. For school districts, structural displacement against shifting demographic patterns and policy dynamics has catalyzed this noted credit stress, and we must be prepared to address changes in rating allocations.

The K-12 sector generally relies on per pupil state funding tied to an average daily attendance formula (ADA) or to actual enrollment populations. Even before the onset of COVID, funding and available resources lacked uniformity, thus limiting academic instruction and extracurricular programs for certain underserved populations. For many years, growing and desirable suburban school districts benefited from expanding tax bases, wealth accumulation and heavy capital investment in school infrastructure and personnel.

As COVID shuttered the economy and kept heavy numbers of K-12 students at home to learn in place, the federal government earmarked about $190 billion in emergency relief funding for the K-12 sector to address education and safety issues. Authorization for the three-part Elementary and Secondary School Emergency Relief (ESSER) funds came through: 1) the March 2020 Coronavirus Aid, Relief and Economic Security Act (CARES); 2) the December 2020 Coronavirus Response and Relief Supplemental Appropriations Act (CRRSA); and 3) the March 2021 American Rescue Plan (ARP).

Operationally, ESSER funds were funneled through the U.S. Department of Education directly to state education agencies, with the funding formulas designed to prioritize school districts with heavier concentrations of students from lower socio-economic families. The three tiers of ESSER funding provided for different types of "allowable expenses" that dictated how states and school districts could utilize the proceeds.

For example, ESSER III funds were earmarked for "learning loss," the purchase of educational technology, deferred maintenance, mental health services and support, summer curriculum and supplemental after-school programs, and preserving continuity of services, such as maintaining proper staffing levels. In many school districts, teacher shortages compromised the delivery of a quality education.

Deadlines to commit and spend ESSER funding have passed and now the most vulnerable school districts are operating on borrowed time in the absence of these federal monies to support programs and personnel investment. Difficult decisions for many of these districts are now being debated under tighter budgetary conditions highlighted by heavy fixed costs and volatile revenue streams, and I suspect that a rebalancing of priorities is occurring with further staffing and curriculum cuts a likely outcome.

As with a number of public finance sectors, K-12 is competing for a shrinking pool of financial resources as states reevaluate their Medicaid, pension, and other essential priorities. For many school districts, the COVID period left heavy deferred maintenance and underfunding beyond what ESSER funds provided, with particular needs for HVAC and security investment as well as for compliance with the Individuals with Disabilities Education Act.

Those less nimble districts risk an erosion in asset quality given limitations on addressing deferred maintenance and absorbing additional leverage. Certain districts are witnessing reduced support for voter-authorized debt and a resistance to higher taxes, factors that could undermine competitive standing.

Even with over 50% of relief funds spent on salaries and benefits, personnel shortages remain a key challenge. Many school districts overcompensated with allocations for the needs of those students who were not provided instruction during school closures and remote learning. Over one-third of school districts reported spending relief funds on curriculum, instructional material and summer learning programs.

In addition to the loss of ESSER funds, other factors are elevating credit challenges and compressing operating margins across the K-12 sector. Broad income and property tax cuts are also undermining funding capacity by shrinking the pool of available resources. Income tax reductions are made at the state level, which in turn lower available state revenue for funding K-12, while lower property tax receipts place limitations on a primary source of local funding for school districts.

Property taxes account for over 35% of public education funding according to the Center on Budget and Policy Priorities (CBPP). A number of states are supporting property tax cuts. Such property tax cuts often pull relatively higher funding levels away from minority school districts. A redistribution of public funds to support private school vouchers further dilutes available K-12 resources.

Not all voucher programs are created equal, but the end result undermines budgetary stability for many school districts. Compounding the stress, certain states, such as Florida and Texas, are widely supporting voucher programs alongside proposals to reduce or eliminate property taxes. In my view, any deep analysis of equitable school funding must address the inadequacies of formulas that may be antiquated and/or based upon irrelevant cost and revenue assumptions. Elevated inflation-induced expenses, particularly for wages and supplies, and the vagaries of revenue forecasting further inhibit funding allocations for K-12.

Demographic shifts, which continue to evolve, are diluting the enrollment profile of many school districts nationwide. Declining birthrates, stringent immigration policies and greater optionality ? given an expanding charter and private school presence ? as well as rising homeschooling activity alter the demand dynamics of a traditional public school setting.

In my opinion, softening demand will likely continue across many school districts, potentially resulting in school consolidation and closures. Fewer public school students result in reduced funding and state aid under established formulas, yet operational and administrative expenses continue until functional viability becomes compromised.

Wealthy school districts are not immune to budgetary pressures as rising home prices and broader affordability issues in certain areas are shutting out many first-time homebuyers, a segment of the population that comes with wider numbers of elementary school age students. Many school districts across the country are experiencing expanding politicization given heated debate between parents and school boards over curriculum choices. These considerations create budgetary pressures and may delay the capital planning process, as potential demographic shifts impact state funding and educational outcomes.

K-12 school districts are operating under a new paradigm. How well a school district can adapt to shifting priorities, revenue variability, expenditure pressures, curriculum alterations and staffing selectivity will determine success or failure. Niche academic curriculum and specialty services may find their way to the cutting room floor. Summer school programs could be pared and overall staff compensation for many ancillary programs will likely be reduced.

Effective governance will go a long way in terms of balancing the needs of a school community against uncertain budgetary challenges. Declining school enrollment affects funding and outcomes and this raises the importance of tweaking state funding formulas to account for better cost estimates and to annually adjust for inflation. These actions could help improve school district funding gaps.

Some experts have suggested that funding formulas be universally based on student enrollment rather than attendance as a way to more accurately assess the number of students being served within a school district. This approach could help smooth over revenue volatility by achieving more predictable funding. Post-COVID, various states have shifted to enrollment-based funding or a hybrid structure to address volatility commonly associated with pure ADA methodologies.

When we think about the state of U.S. school districts, we must make careful security selection and be mindful of prospects for investment performance. As I have stated since the beginning of the year, credit quality remains sound overall, but there are cracks in the veneer. The K-12 sector is a perfect example of this assessment given unique budgetary challenges and the need to adjust the model in order to preserve credit quality. Public K-12 education will always provide a valuable service, but keeping this service relevant requires strong governance with a commitment to prioritizing the right objectives and learning how to adapt to shifting demographics and variable funding streams.