Vanguard Launches Two New Fixed Income Etfs for This Tax-free Market

Vanguard has introduced two municipal bond exchange-traded funds (ETFs) catering to investors seeking tax-free income. The newly launched Intermediate-Term Tax Exempt Bond ETF (VTEI) and California Tax-Exempt Bond ETF (VTEC) provide access to a crucial segment of the municipal bond yield curve, with potential for price appreciation if the Federal Reserve adjusts interest rates. The inverse relationship between bond prices and yields makes this area of the market attractive in a changing rate environment.

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Municipal bond funds are highly valued for their tax advantages. These funds offer tax-free income at the federal level, and if investors reside in the state where the bond was issued, they can also escape state income taxes on this income. The tax savings can be substantial, particularly for residents of states like California and New York, facing high marginal income tax rates. Additionally, the concept of tax equivalent yield is pertinent for high-income investors, indicating the yield needed on a taxable bond to match the income from a tax-free municipal bond.

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Beth Foos, Associate Director of Manager Research at Morningstar, notes the appeal of municipal bonds with low default rates and high credit quality, especially for investors willing to extend their investment horizon to intermediate and long-term strategies for higher yields.

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The Vanguard ETFs, VTEI and VTEC, distinguish themselves by adopting an index-based approach, reflecting 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 contributes to lower fees and increased potential returns, with both ETFs sporting an expense ratio of 0.08%.

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Bond duration plays a pivotal role for municipal bond investors, and VTEI has a duration of about four years, while VTEC focuses on California and has a duration of approximately five years. Jeffrey Johnson, Head of U.S. Fixed Income Product at Vanguard, emphasizes the importance of incorporating longer-dated bonds to mitigate reinvestment risk and capitalize on price appreciation.

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Despite the challenging year for intermediate-term muni bond funds in 2022, marked by rising interest rates and declining bond prices, Vanguard's Intermediate-Term Tax-Exempt Fund rebounded in 2023. Investors withdrew over $520 million from these funds in October 2023 as bond yields surged. However, a noteworthy reversal occurred in November, with $2.8 billion flowing into intermediate-term muni bond funds, followed by an additional $2.3 billion in December, according to Morningstar data.

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As the Federal Reserve signals a reluctance to implement a March rate cut, investors may find municipal bonds an attractive option for diversifying their fixed income holdings. The combination of a low default rate, tax advantages, and stability makes municipal bond funds, particularly those with longer-term perspectives, a solid choice for investors seeking reliable options in the current market landscape.

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