Vanguard has introduced two municipal bond exchange-traded funds (ETFs) designed for investors in pursuit of tax-free income. The recently unveiled Intermediate-Term Tax-Exempt Bond ETF (VTEI) and California Tax-Exempt Bond ETF (VTEC) offer entry into a crucial segment of the municipal bond yield curve.
There’s a potential for price appreciation should the Federal Reserve make adjustments to interest rates. This market segment becomes particularly appealing in a changing rate environment due to the inverse relationship between bond prices and yields.
Municipal bond funds are highly esteemed for their tax benefits. These funds provide income that’s exempt from federal taxes. Moreover, if investors reside in the state where the bond was issued, they can avoid state income taxes on this income as well.
The tax savings can be substantial, especially for residents of states like California and New York, where high marginal income tax rates prevail. Furthermore, the concept of tax equivalent yield is relevant for high-income investors.
It indicates the yield required on a taxable bond to match the income from a tax-free municipal bond.
Beth Foos, Associate Director of Manager Research at Morningstar, highlights the allure of municipal bonds characterized by low default rates and high credit quality.
She particularly emphasizes their attractiveness to investors who are willing to extend their investment horizon to intermediate and long-term strategies in pursuit of higher yields.
The Vanguard ETFs, VTEI and VTEC, set themselves apart by adopting an index-based approach, mirroring a growing trend in the municipal bond market.
VTEC tracks the S&P California AMT-Free Municipal Bond Index, while VTEI follows the S&P Intermediate Term National AMT-Free Municipal Bond Index. This indexing strategy results in lower fees and increased potential returns, with both ETFs featuring an expense ratio of 0.08%.
Bond duration is a crucial factor for municipal bond investors, with VTEI having a duration of around four years, and VTEC, which concentrates on California, boasting approximately five years.
Jeffrey Johnson, Head of U.S. Fixed Income Product at Vanguard, stresses the significance of including longer-dated bonds to minimize reinvestment risk and take advantage of potential price appreciation.
Despite the challenging conditions faced by intermediate-term muni bond funds in 2022, characterized by rising interest rates and falling bond prices, Vanguard’s Intermediate-Term Tax-Exempt Fund experienced a resurgence in 2023.
In October 2023, investors withdrew over $520 million from these funds as bond yields spiked. However, a notable turnaround occurred in November, with Morningstar data indicating a flow of $2.8 billion into intermediate-term muni bond funds, followed by an additional $2.3 billion in December.
With the Federal Reserve signaling a reluctance to implement a rate cut in March, investors might consider municipal bonds as an appealing option for diversifying their fixed-income holdings.
The combination of a low default rate, tax advantages, and stability renders municipal bond funds, especially those with longer-term perspectives, a robust choice for investors seeking reliable options in the current market landscape.
