investing

Sit Tax-Free Income Bets on Housing Bonds

This fund looks for undervalued corners of the muni market.

It’s easy to see the appeal of municipal bonds for investors in the highest tax brackets. These IOUs, issued by state and local governments, are typically exempt from federal taxes as well as from most state and local taxes for hometown buyers. So investors who hold munis in taxable accounts enjoy higher effective yields than they’d get on comparable taxable debt. And now may be a good time to buy. Although demand for the bonds remains relatively constant from year to year, so far in 2018 muni bond issuance is running 15% below levels for the same period last year. A shortage of new supply boosts the value of existing bonds, and the current supply-and-demand imbalance should continue for now.

Like taxable bonds, munis come with varying maturities, credit ratings, sources of revenue and guarantees. Many investors prefer to leave those decisions to the pros. The managers at Sit Tax-Free Income (SNTIX) scour the muni market for bonds with robust yields in undervalued sectors. The fund yields 2.7%—equivalent to a 4.5% yield for a taxpayer in the highest, 40.8% federal income tax bracket.

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Sit has loaded up on housing bonds. The bonds raise money to develop affordable single- and multi-family housing and are backed by mortgage revenue. These issues offer juicy yields, the managers say, but they come with a risk that homeowners will pay off their loans early, which would curtail future interest income. Such bonds constitute 48% of the fund’s assets, compared with 1.9% for the average muni fund.

Some 20% of the fund’s bond holdings aren’t scored by credit agencies, compared with 6.4% in the average muni fund. Most of the nonrated issues are com­parable to bonds rated BB or BB+ (the highest ratings for non-investment-grade debt), and the fund’s overall credit quality equates to single-A, says senior portfolio manager Paul Jungquist.

The portfolio’s duration (a measure of interest rate sensitivity) is currently 4.0, implying that the fund’s share price would drop by roughly 4% if rates were to rise by one percentage point. The fund has lagged its benchmark, the Bloomberg Barclays Municipal 5-Year index, in just two calendar years out of the past 10, including so far in 2018.

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