Vanguard launches two new ETFs to hit this sweet spot of tax-free fixed income

Published Fri, Feb 9 20241:52 PM ESTUpdated Fri, Feb 9 20243:02 PM EST

Investors with a focus on tax-free income have two new choices to consider from Vanguard as the asset manager launches a pair of municipal bond exchange-traded funds. The Intermediate-Term Tax Exempt Bond ETF (VTEI) and the California Tax-Exempt Bond ETF (VTEC) debuted last week, giving investors access to a key part of the muni bond yield curve – a spot that could see price appreciation when the Federal Reserve dials back interest rates. Bond prices and yields move inversely to one another. "You're still seeing relatively low default rates, high credit quality and if investors are willing to edge a little further out on the yield curve into intermediate – and maybe into even long strategies – they are looking for some more yield there," said Beth Foos, associate director, manager research at Morningstar. Tax advantages The biggest selling point for municipal bond funds is the tax-free income they provide. On a federal level, muni bond income is free of income taxes, but investors can also avoid state levies on this income if they reside in the state where the bond was issued. The savings can be considerable for California residents, who could now see a top marginal income tax rate of 14.4%, or New Yorkers, who face a top rate of 10.9%. For high income investors, there's also the matter of tax equivalent yield – the amount of yield you'd have to generate on a taxable bond in order to receive a similar amount of income on a tax-free issue. Someone who's in the 32% federal income tax bracket and is receiving a tax-free yield of 3% on a muni bond would have to find a taxable bond with a 4.41% yield in order to generate comparable income, according to New York Life Investments . Bond duration is another key consideration for muni investors. The Fed's runup in interest rates and the inverted yield curve made short-dated fixed income investments attractive – particularly with certificates of deposit and money market funds yielding upward of 5%. Strategists have recommended adding duration – that is, longer-dated bonds with more price sensitivity to changes in rates – to mitigate reinvestment risk once rates decline and to benefit from price appreciation. Indeed, VTEI has a duration of about four years, while the California-focused VTEC has a duration of about five years, said Jeffrey Johnson, head of U.S. fixed income product at Vanguard. What's notable about VTEI and VTEC is that both funds take an index-based approach, which Johnson says is a developing trend within the muni market. VTEC follows the S & P California AMT-Free Municipal Bond Index, while VTEI tracks the S & P Intermediate Term National AMT-Free Municipal Bond Index. That approach results in lower fees, as well as the prospect of pocketing more of your return: Both ETFs have an expense ratio of 0.08%. Flows trending Investors in intermediate-term muni bond funds took their lumps in 2022, as the Fed raised interest rates and bond prices declined. The Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) had a total return of -6.91% that year, but it rebounded in 2023, rising 5.82%. Money is also coming back into intermediate-term muni national funds. Investors yanked more than $520 million from these funds in October 2023, according to Morningstar Direct, as bond yields leapt and the rate on the 10-year Treasury touched 5%. However, in November, $2.8 billion in assets flowed into intermediate-term muni bond funds, followed by another $2.3 billion in December, Morningstar found. The question is whether investors who have been crowding in cash may be more inclined to add exposure to munis to diversify their fixed income holdings. Indeed, the Fed has indicated that a March rate cut is unlikely, so yields on cash-like investments may remain attractive for a while longer. "If you did have money parked on the sidelines, when do you want to jump in?" said Foos of municipal bond funds. "Because of the low default rate, the tax advantages and the stability that longer-term investors could realize, it's still a solid option."