Navigating the Storm: Assessing Risk in Municipal Bond Portfolios Amid Rising Rates and Credit Concerns

The AllianceBernstein National Municipal Income Fund (AFB) has become a microcosm of the challenges plaguing municipal bond portfolios in 2025. With its net asset value (NAV) plummeting 5.4% in Q2 and assets under management (AUM) falling to $337.93 million, the fund's struggles highlight critical vulnerabilities in a sector increasingly strained by rising interest rates and deteriorating credit quality. For investors, AFB's performance serves as a warning: municipal bond risks are no longer theoretical—they are materializing, demanding a rigorous reassessment of portfolio strategies.

The Perfect Storm: Duration, Leverage, and Rates

AFB's NAV decline stems from a trifecta of factors. First, its effective duration of 12.06 years makes it acutely sensitive to interest rate fluctuations. A 1% rise in rates could reduce the portfolio's value by ~12%, a vulnerability exacerbated by its 46.17% leverage—funded via instruments like Tender Option Bonds and Variable Rate Demand Preferred shares. These tools amplify returns in stable markets but magnify losses when rates climb.

Second, credit quality concerns loom large. While 72.04% of AFB's holdings are rated A or higher, 25% are allocated to high-yield municipals, including 17.88% in BBB-rated bonds—a rating just one step above junk status. Smaller allocations to BB (7.00%) and B (0.52%) bonds further heighten default risks, especially in states like Illinois, where fiscal mismanagement threatens bond issuers.

Dividend Yield: A Tempting Mirage?

AFB's 4.66% dividend yield appears attractive, but its sustainability is precarious. The fund's quarterly net investment income of $0.12 per share barely covers its $0.472 annual dividend. As unrealized losses approach realized status, the dividend could face cuts unless NAV stabilizes. Worse still, the absence of yield-to-worst (YTW) disclosures—a critical metric for assessing worst-case bond scenarios—leaves investors in the dark about downside risks.

The Broader Municipal Bond Market: Where Is the Safety?

AFB's struggles are not isolated. The broader municipal bond market faces headwinds:
1. Rate Uncertainty: The Federal Reserve's pause-and-resume policy keeps rates volatile, pressuring long-duration portfolios.
2. Credit Downgrades: Fiscal strains in states like Illinois, New Jersey, and California could trigger downgrades, eroding bond values.
3. Liquidity Risks: Leverage-heavy funds like AFB may struggle to meet redemptions if market liquidity tightens.

Investment Strategy: Navigating the Risks

For investors seeking municipal bond exposure, here's how to proceed:
1. Shorten Duration: Opt for funds with durations under 7 years, such as PIMCO Municipal Income Fund (PMF), which has a 5.3-year duration and a BBB+ average credit quality.
2. Avoid Leverage: Steer clear of funds relying on Tender Option Bonds or VRDP shares unless their credit quality is fortress-like.
3. Prioritize Credit Quality: Focus on portfolios with <10% exposure to BBB or lower-rated bonds.
4. Monitor YTW: Demand transparency—avoid funds that omit YTW disclosures.

Conclusion: AFB's Lesson for Investors

AFB's decline underscores a stark truth: municipal bond investing has grown riskier. Its blend of high duration, leverage, and credit exposure makes it a speculative play, suitable only for investors with a high tolerance for volatility. For most, especially those seeking stable income, safer alternatives exist.

The municipal bond market's future hinges on two variables: whether rates stabilize or continue rising, and whether states can resolve fiscal crises. Until then, conservative investors should prioritize diversification, shorter durations, and strong credit profiles. AFB's NAV erosion is a cautionary tale—a reminder that in fixed income, the pursuit of yield must always be balanced with a cold-eyed assessment of risk.

Investment recommendation: Consider shifting allocations to funds like PMF or MHM, which offer comparable yields with lower duration and credit risk. For AFB investors, now may be the time to reassess exposure before unrealized losses become a permanent drag on returns.*