Evaluating Franklin Federal Intermediate-Term Tax-Free Income Fund: A Tax-Advantaged Strategy in a Rising Rate World

The municipal bond market in 2025 is navigating a complex landscape of rising interest rates, shifting credit dynamics, and evolving investor priorities. For income-focused investors, tax-free municipal bonds remain a critical tool to hedge against inflation and tax drag. Among the key players in this space, the Franklin Federal Intermediate-Term Tax-Free Income Fund (FKITX) stands out as a compelling option. This article evaluates FKITX's competitive positioning, its strategic advantages in a rising rate environment, and the broader implications of tax-free income for portfolio resilience.

A Tax-Advantaged Edge in a High-Yield Environment

The municipal bond market has historically offered a dual benefit: tax-exempt income and diversification from equities. As of June 2025, the Bloomberg Municipal Bond Index has a yield-to-worst (YTW) of 3.96%, a level only exceeded 4.9% of the time over the past decade. For investors in high tax brackets, the tax-equivalent yield of municipal bonds becomes even more compelling. For example, a 3.96% municipal yield for a 35% tax bracket investor translates to a 6.1% taxable-equivalent return—outperforming many corporate and Treasury alternatives.

FKITX, with a trailing dividend yield of 3.14%, slightly exceeds the 3.10% category average for municipal intermediate-term funds. This edge is amplified by its 0.57% expense ratio, 23% lower than the average for its peer group. In an era where cost efficiency is paramount, FKITX's low-cost structure allows investors to retain more of their returns.

Navigating Rising Rates: Duration and Credit Discipline

A key challenge in a rising rate environment is managing interest rate risk. FKITX's intermediate-term duration—focused on bonds with maturities typically between 3–10 years—positions it to outperform long-duration alternatives while mitigating volatility. Shorter-duration municipal bonds are less sensitive to rate hikes, making them ideal for a 2025 environment where the Federal Reserve has signaled continued tightening.

The fund's portfolio composition further underscores its strategic approach. Holdings like PATRIOTS ENERGY GROUP GAS SUPPLY REV 5.25% and TENNERGY CORP TENN GAS REV 5.5% reflect a focus on revenue-backed municipal bonds, which derive income from specific projects (e.g., energy infrastructure). These securities often carry strong credit profiles, as their repayment is tied to cash flows from essential services. Additionally, FKITX's 18% portfolio turnover rate—well below the category average of 37%—highlights its disciplined approach to minimizing transaction costs and preserving capital.

Active Management and Credit Selectivity

While passive strategies have gained traction, active management remains critical in the municipal bond market. FKITX's underperformance in Q2 2025 (due to yield curve positioning) illustrates the risks of market timing but also highlights the fund's adaptability. By June 2025, FKITX returned 1.0%, outperforming the 0.7% category average, showcasing its ability to capitalize on dislocations.

The fund's active approach extends to credit selectivity. At least 80% of its assets are invested in municipal securities rated in the top four categories by recognized rating agencies. This emphasis on quality is particularly valuable in a market where high-yield municipals, though outperforming investment-grade bonds by 2 bps year-to-date, remain volatile. FKITX's conservative credit profile aligns with its objective of capital preservation, making it a safer harbor for risk-averse investors.

Strategic Advantages in a Tax-Exempt Framework

Tax-free income is FKITX's most potent differentiator. With municipal bond issuance reaching $256 billion through June 2025—a 16% year-over-year increase—the fund's active management allows it to exploit inefficiencies in the secondary market. For instance, dislocations in sectors like prepaid gas and housing have created opportunities for yield enhancement, with spreads widening to +100–140 bps over AAA benchmarks. FKITX's ability to identify undervalued credits while maintaining high credit quality gives it an edge in a market where liquidity is both a challenge and an opportunity.

Investment Implications

For investors, FKITX represents a balanced approach to tax-free income and risk management. Its low expense ratio, active credit strategy, and intermediate-term duration make it well-suited for a rising rate environment. However, its performance highlights the importance of long-term perspective: while the fund earned an A grade in June 2025, its 10-year returns (grade D) suggest consistency may vary.

Recommendation: FKITX is ideal for investors prioritizing tax efficiency and seeking moderate income with lower volatility. However, those with a shorter time horizon or higher risk tolerance may need to supplement with high-yield municipal alternatives. As the municipal bond market continues to evolve, FKITX's disciplined approach and tax advantages position it as a strong contender in the competitive tax-free income space.

In a world where tax drag and interest rate uncertainty dominate, FKITX's strategic focus on quality, cost efficiency, and tax-free income offers a compelling roadmap for income investors.