MUnicipal bonds and related exchange-traded funds are facing headwinds to begin 2022, much of which stems from Federal Reserve plans to imminently raise interest rates.
On the other hand, there are still strong fundamentals in favor of the munis, even with Fed tightening looming as early as next month, indicating that rate hike jitters could provide opportunities with ETFs such as American Century Diversified Municipal Bond ETF (NYSEArca: TAXF).
As experienced municipal bond investors, one of the main factors to consider when evaluating this segment of the bond market is the ability of issuers, including cities and states, to collect taxes. Fortunately, things are bright on that front.
“In a report released (last month), the municipal bond team at MacKay Shields noted that higher pricing pressures can mean municipalities collect more taxes that support bond redemptions. For example, toll road operators often adjust their debt service coverage levels for inflation as part of their debt covenants,” reports Amanada Albright for Bloomberg.
The actively managed TAXF features exposure to munis issued by various states, with its top five exposures being California, Texas, New York, Florida and Arizona as of the end of last year. Arizona, Florida and Texas are three of the fastest growing states in the country. Translation: Tax bases in these states are broadening, potentially highlighting long-term appeal with TAXF.
As for California, the state is replacing some of the jobs lost during the coronavirus pandemic, and the state’s coffers appear generally healthy today, indicating that TAXF’s California holdings should be stable for the foreseeable future.
“Among the biggest threats from rising interest rates will be the blow to low-coupon bonds. In recent years, low-coupon bonds have been embraced by investors because they can offer higher yields, but their longer duration can pose a risk during rate hikes,” according to Bloomberg.
For its part, TAXF, which holds 413 municipal bonds, has a modest exposure to high yield. More than 71% of ETF holdings are rated AAA, AA or A. TAXF also minimizes interest rate risk. The duration of the fund is 6.12 years, according to data from the issuer. That puts it firmly in medium-term territory, the segment of the municipal bond space that some experts say is best suited to weather rising interest rates.
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