2023-06-05 09:00:00 ET
Summary
- The Vanguard Tax-Exempt Bond ETF seeks to track Standard & Poor's National AMT-Free Municipal Bond Index, which measures the performance of the investment-grade segment of the municipal bond market.
- Along with reviewing the VTEB ETF in detail, including its index, I compare its performance against two CEFs, one with and one without leverage.
- While VTEB investors had a smoother ride, the ETF’s return was inferior to either of the two CEFs I compared it against. Investors might consider a swap trade.
(This article was co-produced with Hoya Capital Real Estate )
Introduction
This article reviews an ETF investing in the municipal bond market, an area dominated by Closed-End-Funds, most of which use leverage to enhance their yield. For some investors, that extra yield is not worth the added risk leverage adds, thus the growing popularity of ETFs that do not incorporate leverage into their strategy. This fund I choose to review is the Vanguard Tax-Exempt Bond Index Fund ETF Shares ( VTEB ). As we will see later, there are municipal bond CEFs without leverage.
The above chart is the Standard & Poor’s National AMT-Free Municipal Bond Index , on which the VTEB ETF bases it investment choices. As expected, it started dropping as the FOMC commenced raising the Fed Funds rate. With that action having a negative effect on bond prices as interest rates rose, the Yield-to-Maturity broke the COVID high before retreating in 2023.
Vanguard Tax-Exempt Bond ETF review
Seeking Alpha describes this ETF as:
The Vanguard Tax-Exempt Bond ETF invests in tax exempt investment-grade municipal bonds issued by state or local governments or agencies with a minimum term to maturity greater than one calendar month. The fund seeks to track the performance of the Standard & Poor’s National AMT-Free Municipal Bond Index . This index includes municipal bonds that are also exempt from the federal alternative minimum tax ((AMT)). VTEB start in 2015.
VTEB has $26.5b in assets and provides investors with a TTM Yield of 2.4%. Fees are only 5bps.
Index review
S&P describes their index as:
The S&P National AMT-Free Municipal Bond Index is a broad, comprehensive, market value-weighted index designed to measure the performance of the investment-grade tax-exempt U.S. municipal bond market. Bonds issued by U.S. territories, including Puerto Rico, are excluded from this index.
Source: spglobal.com Index
They also provide data on the index and index construction rules.
Despite its name, the index rules do not openly state bonds must be AMT-Free.
Holdings review
Vanguard provides some comparisons for VTEB against its benchmark.
VTEB holds bonds from every state except Montana. There are 19 states with at least 1% exposure in the ETF.
How the states and localities in California and New York, both states with shrinking populations and income, will influence results. I failed to find the type of issuers and their allocations, something most managers share with their fund's investors. The maturity schedule shows about 6% maturing in the next year.
Looking at the total portfolio, there are 565 bonds maturing before 2025, representing just over 6% of the weight. Their WAC of 4.79% is higher than the portfolio's. That WAC is what A-rated 30-year Municipals currently yield so it doesn't feel like VTEB will benefit much via maturity dollars being re-invested into new bonds. I say that then look at distribution growth and have to question my own statement.
Morningstar gives the portfolio an AA- rating.
Top 20 holdings
While VTEB holds over 7200 bonds, the bottom half of the portfolio only accounts for 15% of the total weight: many at under .01% each. The average bond price is just over $103.
Distribution review
The increasing payouts since the FOMC started raising the Fed Funds rate indicates success in rolling matured bonds into higher coupon bonds more so than I would have thought possible based on where rates were for 25-30 years, the standard life of a municipal bond issue. That seems to have stalled so far in 2023. Seeking Alpha gives VTEB a "C+" grade for this factor.
Besides dividends, Seeking Alpha quant grades or ranks ETFs on multiple factors, including how SA Contributors rate the ETF.
Portfolio strategy
When I am deciding between bond funds, I look at several factors, three of which are: yield, return, and StdDev. If the first two are close, I want to own the one with the smallest StdDev, thus the least volatile performance. I included two CEFs, the Nuveen Quality Municipal Income Fund ( NAD ), which has 40% leverage, and the Nuveen Select Tax-Free Income Portfolio ( NXP ), which does not use leverage and one I own. I have articles on both for a closer look at either CEF.
VTEB's StdDev is less than 50% of either of the CEFs, including the no-leverage one. So, while the actively managed CEFs had much higher returns, so were their risk statistics. NXP had the best combination of return and risk.
Final thoughts
For investors wanting to use an ETF for their national municipal bond exposure and rank lower price volatility over return, VTEB should match their criteria. If yield is a higher priority, consider swapping VTEB for the NXP where you still avoid leverage.
If the investment horizon for these funds is under three years, even those in the higher Federal tax brackets might want to consider the 5+% available in CDs instead. While the FOMC most likely will start reducing the FFR by 2026, which could allow for a better return over CDs, there is no guarantee.
For further details see:
VTEB: Smoother Muni-Bond Ride Comes With Big Cost