FMHI: Tax-Efficient Income in a Rising Rate World

In an era where central banks are tightening monetary policy and investors grapple with the dual challenges of inflation and tax drag, the search for income-generating assets that balance yield, risk, and tax efficiency has never been more urgent. Enter the First Trust Municipal High Income ETF (FMHI), a fund that leverages high-yield municipal bonds to deliver a compelling proposition for investors navigating a rising rate environment. By dissecting FMHI's strategy, we uncover how it offers a unique blend of tax-advantaged returns and resilience in a market where traditional fixed-income assets are under pressure.

The Tax-Efficiency Edge

FMHI's primary appeal lies in its focus on federally tax-exempt municipal bonds, which shield investors from federal income taxes and, in many cases, state and local taxes as well. For high-tax-bracket investors, this is a critical advantage. As of July 31, 2025, FMHI's 30-day SEC yield of 3.43% translates to a taxable equivalent yield of 5.80%, assuming a 2025 top tax bracket of 37% plus 0.9% Medicare surcharge. This means investors in taxable accounts can compare FMHI's yield to that of taxable high-yield bonds without sacrificing after-tax returns.

High-Yield Munis: A Balancing Act

While municipal bonds are traditionally associated with investment-grade securities, FMHI tilts toward high-yield (junk) munis, which offer higher coupons to compensate for increased credit risk. As of June 30, 2025, the fund's portfolio includes 14.16% in BB-rated bonds and 1.13% in B-rated bonds, alongside 41.34% in unrated (NR) securities. This strategy amplifies yield but requires careful credit analysis. The fund's active management approach allows it to target municipalities with strong fundamentals, even if they lack formal ratings.

Critics may argue that high-yield munis are more vulnerable to default in a slowing economy. However, the current macroeconomic backdrop—characterized by robust state and local government budgets due to federal stimulus and low unemployment—provides a buffer. Municipal defaults remain historically rare, and FMHI's focus on high-yield munis taps into this relative safety while boosting income.

Rising Rates and Duration Risk

A common concern in a rising rate environment is the sensitivity of long-duration bonds to price declines. FMHI's weighted average effective duration of 8.65 years and maturity of 17.89 years suggest it is not immune to rate hikes. Yet, the fund's strategy mitigates this risk in two ways:

1. Yield Premium: High-yield munis typically offer higher coupons than investment-grade counterparts, which can offset capital losses when rates rise.
2. Tax Arbitrage: The tax-exempt nature of municipal income means investors can tolerate lower pre-tax returns than taxable investors. For example, a 3.43% yield in FMHI is effectively 5.80% in taxable terms, making it competitive with higher-yielding taxable bonds that carry greater duration risk.

Cost Structure and Liquidity

FMHI's 0.70% expense ratio is modest for an actively managed municipal bond ETF, especially given the fund's access to fee waivers. This cost is offset by its low liquidity premium: as of August 4, 2025, the fund trades at a 0.00% bid/ask premium, with a 30-day median spread of 0.15%. This tight spread ensures investors can enter and exit positions without significant slippage, a critical factor for ETFs with niche strategies.

The Case for FMHI

For investors seeking tax-efficient income in a rising rate environment, FMHI offers a compelling case:
- High Yield, Low Tax Drag: The fund's 3.43% yield, combined with tax-exempt status, outperforms taxable alternatives in high-tax jurisdictions.
- Active Duration Management: While long-dated, the fund's active approach allows it to adjust to rate shifts more nimbly than passive benchmarks.
- Credit Diversification: A mix of rated and unrated bonds provides access to higher yields without overexposure to any single credit.

However, investors should weigh the risks: the fund's high-yield focus and long duration make it volatile in a sharp rate spike or economic downturn. Diversification and a long-term horizon are key.

Final Take

FMHI is not a magic bullet, but it is a well-constructed tool for investors who prioritize tax efficiency and income stability over capital preservation. In a world where traditional bond yields are rising but remain below historical averages, the fund's ability to generate tax-advantaged income at a reasonable cost makes it a standout option. For those in high-tax brackets or seeking to hedge against inflation, FMHI's high-yield municipal strategy offers a rare combination of resilience and reward.

Investment Advice: Consider FMHI as a core holding in a diversified fixed-income portfolio, particularly for investors in states with high income taxes. Pair it with shorter-duration treasuries or TIPS to balance rate risk. Monitor credit spreads and municipal bond defaults for early warning signs of stress.