Navigating muni bonds: Three potential paths to success

From the Fixed Income Desk

Even with global positioning systems and mapping software, an experienced taxi or rideshare driver’s knowledge of roads, intersections, and traffic patterns is valuable in ferrying busy passengers. A driver who knows a good shortcut through a city is more than worth their tip.

The municipal bond market is like a big city. The market consists of 50,000 issuers and bonds that differ in credit quality, coupon level, and call options, among many other characteristics. Active managers must navigate these complexities with the same skill a driver uses to avoid traffic jams and construction.

At Vanguard, we use our in-depth knowledge of municipal bonds to map out opportunities and steer around market challenges. We currently see three alpha opportunities to generate outperformance using guideposts we refer to as our “three Cs”: credit, carry, and convexity.  

Just as we do in the rest of our nearly $200 billion¹ active municipal mutual fund complex, we apply the three Cs in our first two active muni ETFs: Vanguard Core Tax-Exempt ETF (VCRM) and Vanguard Short Duration Tax-Exempt ETF (VSDM). These new ETFs are designed to help your clients work toward their investment goals with confidence and precision.

Let’s examine each more closely. 

Credit

With a team of more than 20 credit analysts, research is one of our primary strengths. We look to identify mispriced issuers with strong or improving fundamentals and those for which higher yields compensate investors for the extra risk taken.

From a credit perspective, we see ample opportunity in muni bonds. High-income U.S. investors dominate the tax-exempt market, where many tend to buy bonds individually or as part of separately managed accounts. Those investors gravitate primarily to AAA and AA rated bonds in order to minimize credit risk. But that behavior means that lower-rated bonds, which are often overlooked, may offer better-than-expected yields.

• We think the best value for municipal credit spread is in bonds rated A and below.
• Research and security selection can add value at any credit level of the muni market.

Carry

Carry can encompass a few strategies. Most simply, it can mean to outyield a benchmark, often by adding beta from credit or duration. Carry also involves optimizing positions at different points in the yield curve based on roll-down—the increase in value of a bond as it approaches maturity.

• Amid the current interest rate outlook, we expect carry to play an important income-generating role in our portfolios.

Convexity

When interest rates change, a bond’s price can fluctuate. We measure this sensitivity to interest rate changes as duration. But for municipal bonds with call options, duration can be far from consistent; the extent to which duration can change for a given bond is referred to as convexity.

Here’s an example. Let’s say a bond issuer’s option to call a bond early goes out-of-the-money as market yields rise above the bond’s coupon level. (Why would an issuer want to refinance debt at a higher rate?) The duration for this security could rise from eight to 15 years as market trading adjusts from an expected life of 10 years (call date) to that of 30 years (stated maturity).

It’s difficult to measure and manage this risk for tens of thousands of bonds, which is why many municipal investors (direct retail, SMAs, even many asset managers) usually allocate to avoid these risks altogether (as much as they can). The resulting mispricing of convexity leads to instances in which we can often construct a portfolio with benchmark-relative alpha potential without the downside.

In sum, a callable municipal bond’s sensitivity to interest rate changes can rise (or fall) as market yields take large swings, especially as market yields cross over (or under) the coupon rate.

• In a market with thousands of callable bonds (roughly 80% of the market), convexity becomes a complex but meaningful factor in valuations. Only a sophisticated active manager can model forward pricing and act on opportunities.
• Our team has decades of experience analyzing convexity so it can be used as a key element in not only managing duration risks but also extracting value.
• It’s a primary performance driver for intermediate and long muni funds such as VCRM.

Experienced active managers at the wheel

Like a savvy cab driver uses their own knowledge and awareness to help navigate gridlock, we use our experience with credit, carry, and convexity to unlock value for Vanguard’s muni fund investors.

Our job as an active manager is to use the flexibility of these levers to take advantage of opportunities as they arise, even as we do the traditional work of analysis across sectors, regions, and issuers.

VCRM

VCRM is a broadly diversified ETF with an investment mandate that allows us to invest across the full yield curve and across all sectors. That empowers us as active managers to use all the tools at our disposal—even as we maintain the risk management that clients have come to expect from Vanguard.

• VCRM can serve as the long-term, tax-efficient centerpiece of a client’s taxable portfolio.

VSDM

We also introduced VSDM to serve muni clients who prefer a lower level of interest rate risk. While delivering upon clients’ expectations for lower overall price volatility, the front end of the muni curve also offers substantial opportunities to add value through credit selection and carry.

• VSDM can help clients with low-duration risk tolerance participate in the muni market—or help those with cash needs in the foreseeable future.

Vanguard has managed active muni bond funds for nearly 50 years, and we have a long history in both funds and ETFs. Combining these capabilities is a natural evolution for our team.

Discover more:

Vanguard Core Tax-Exempt Bond ETF (VCRM)

Vanguard Short Duration Tax-Exempt Bond ETF (VSDM)

1 Assets under management as of November 30, 2024.

 

Notes:

For more information about Vanguard funds or Vanguard ETFs^®, visit advisors.vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including possible loss of principal.

Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

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.