Get targeted municipal exposure with low-cost Vanguard ETFs

With the launch of two municipal bond ETFs in January 2024, Vanguard now offers four muni ETFs in all, providing low-cost, tax-efficient, and liquid coverage across the muni yield curve.

Investors have been slower to adopt muni ETFs than to adopt ETFs targeting other asset classes. Nearly 90% of today’s municipal fund and ETF market is in active mutual funds.¹ Increasingly, though, investors focusing on lowering cost, increasing tax efficiency, and taking tax-loss harvesting opportunities have fueled accelerated growth in the muni ETF market.

ETFs offer some of the most efficient and flexible access to the muni bond universe. And as their assets have tripled over the past five years to about $122 billion, ETFs are potentially a powerful way to invest in munis compared with buying individual munis directly.²

 

The case for municipal bonds

It’s important for investors to pay attention to their after-tax yields. After two years of Federal Reserve interest rate increases, the federal funds rate as of this writing is 5.25%–5.50%, and the fixed income asset class in general offers higher yields than it did during much of the last decade.

For high-net-worth investors, taxes can erode these attractive yields. Municipal bonds generally offer lower absolute yields, but because their income is exempt from federal (and sometimes state) taxes, their after-tax yields can often surpass the yields of taxable bonds for investors in the top tax brackets.

With markets now shifting to the prospect of future rate cuts, muni investors may be about to capitalize on these higher yields, compared with cash or other short-term savings instruments, while they last.

 

The case for using ETFs to obtain muni exposure can potentially grow stronger when you consider the concentrated positions, logistical complexity, and relatively high liquidity costs of managing a portfolio of muni bond ladders or separately managed accounts (SMAs) of munis.

Some investors still choose these relatively complicated structures even as ETFs have started to potentially minimize the complexities. This may represent an opportunity for advisors.

Greater optionality with ETFs

One challenge of holding individual muni bonds is that portfolio maintenance can be time-consuming, especially if the portfolio needs adjusting. Using Vanguard muni ETFs, investors could fine-tune portfolios in any number of ways with relative ease. Whether risk tolerance or duration targets change, coupon payments need reinvestment, or larger sums of cash are added or withdrawn, ETFs allow for more efficient ways to make portfolio adjustments large and small.

Diversification

Building a portfolio using individual bonds leaves an investor increasingly open to risk, whether it is credit, sector, issuer, default, or call risk.

Although the municipal bond market generally maintains a higher credit quality than the corporate bond market, credit risk is still present. Individual issuers can run into trouble, and it is important for investors to remain diversified to hedge against this risk. ETFs tend to provide diversified exposure across the municipal market. For example, VTEB currently holds over 10,000 individual bonds. This diversification can help lower the volatility of a fixed income portfolio. Furthermore, it empowers portfolio managers to delve deeper into the credit-rating spectrum, thus enhancing yield from the credit part of the municipal market without meaningfully increasing credit risk.

Let’s also consider call risk. About 80% of munis are callable, presenting a clear challenge to investors looking to maintain exposure or build ladders with individual bonds.³ A bond could get called and leave the investor with uninvested cash; or worse, an investor could buy a bond thinking it will retire early before extending to its final maturity date. A diversified portfolio of municipal bonds offered through an ETF can help limit the impact that such unpredictable outcomes can introduce into a portfolio.

Liquidity

When building a bond ladder or SMA, buying bonds is the easy part. The challenge is selling them, whether to get cash earlier or to harvest losses. With bond ladders and SMAs typically trading in small lots, it can be hard to get a fair price, forcing the bonds to be sold at a discount. Many individual muni bonds don’t trade intraday, and even fewer trade electronically. This is where a municipal ETF can be a crucial source of liquidity.

Around 80%–90% of fixed income ETF trading occurs on the secondary market between buyers and sellers of the ETF on an exchange. The fact that these transactions don’t require trading the underlying bonds can often mean that ETFs trade with tighter spreads than their underlying basket of bonds.

In fact, the ETF has emerged as a price discovery tool wherein relatively liquid secondary market ETF trading can help determine prices of individual bonds.

Generally, an ETF—such as VTEB, which trades at tight spreads of 2 bps—is much less expensive than buying any of the bonds in its basket, which trade at an average spread of 18 bps.⁴ This liquidity “pickup” can potentially amount to several years’ worth of an ETF’s expense ratio, depending on an investor’s time horizon.

Costs

Vanguard’s large scale and investor-owned⁵ structure allow us to offer municipal bond ETFs with an average expense ratio of 0.07%, versus the 0.34% industry average for ETFs.⁶ We also employ a team of deep sector specialists in the management of the portfolio who aim to keep tracking error and transaction costs low.

Over the five years ended December 31, 2023, VTEB experienced the lowest tracking error volatility of any municipal ETF on the market.⁷ This is due to the level of experience and expertise our Fixed Income Group has developed over 40 years of managing municipal assets.

With the holding cost of ETFs being this low, it’s important for investors to compare the added costs of customizing an SMA or bond ladder and ask themselves whether those costs are worth it. For many investors, even high-net-worth ones, the answer may be no.

Takeaways

SMAs and bond ladders containing munis certainly still have a place, as the inherent customization of such approaches is a big allure for many investors.

ETFs, however, can add value by providing more optionality, diversification, and liquidity and lower trading and holding costs. ETFs can also help with tax-loss harvesting or with reinvesting cash proceeds efficiently.

With today’s high yields, municipal bonds are an important asset class to consider for high-net-worth investors as they think about maximizing after-tax returns.

Vanguard’s growing lineup of muni ETFs—namely VTES, VTEI, VTEB, and VTEC—are potentially useful, low-cost, and liquid tools that can fill portfolio needs efficiently and with relative ease.

Take a look at our full list of fixed income ETFs.

 

1 Source: Morningstar, Inc., as of January 31, 2024.

2 Asset figure as per Morningstar, Inc., as of January 31, 2024.

3 Source: Bloomberg, as of January 31, 2024.

4 Both cited trading spreads are as per Bloomberg, as of January 31, 2024.

5 Vanguard is owned by its funds, which are owned by Vanguard’s fund shareholder clients.

6 The expense ratio comparison is as per Morningstar, Inc., as of January 31, 2024.

7 Vanguard calculations, based on data from Morningstar, Inc.

 

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Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal alternative minimum tax.

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. We recommend that you carefully review the terms of the consent and consult a tax advisor before taking action.