Muni Bonds Coming Back Into Style | ETF Trends

In what’s a positive sign for conservative, income-seeking investors, muni bonds are trending higher in 2023. That’s supporting upside for a variety of exchange traded funds, including the Vanguard Tax-Exempt Bond ETF (VTEB).

VTEB, which follows the Standard & Poor’s National AMT-Free Municipal Bond Index and yields 3.48% on a 30-day SEC basis, is higher by 1.39% year-to-date. Home to 7,419 municipal bonds, VTEB has the diversification investors crave in aggregate muni strategies. Moreover, VTEB is an investment-grade fund, so its credit risk is low.

Speaking of the credit outlook for munis, the primary avenue for assessing credit quality of municipal bonds is to evaluate the tax-collecting capabilities of issuers (cities and states). Broadly speaking, tax collections are solid across most of the country.

“Income tax collections were mixed in April, but sales and property taxes continue to grow. Also, most state and local governments still have plenty of cash on reserve in case the economy performs worse than our economists expect. That cash comes from all the aid that the federal government provided, several hundred billion dollars, in fact, to municipal issuers in response to COVID,” noted Mark Schmidt, Morgan Stanley head of municipal strategy.

Rate Pause Could Help VTEB

VTEB’s holdings have an average duration of 5.8 years, putting the fund in intermediate-term territory, with an average stated maturity of 13.3 years. In other words, the longer the Federal Reserve goes without raising interest rates and the more Treasury yields decline, the more VTEB stands to benefit.

“Longer maturity bonds generally offer higher returns, but of course, with higher risk as well. Right now, we actually see superior risk adjusted returns in a 1 to 5 year or 1 to 10 year ladder,” added Schmidt.

Investors looking for lower duration and short maturities with municipal bonds can consider the Vanguard Short-Term Tax-Exempt Bond ETF (VTES). That ETF debuted in March and follows the S&P 0-7 Year National AMT-Free Municipal Bond Index, meaning its holdings have maturities ranging from one month to seven years. The average stated maturity of the 966 bonds residing in VTES is 3.1 years, according to issuer data.

Another point in favor of munis, whether accessed by VTEB or VTES, is that the beneficial tax treatment offered by the asset class — federal and state deductions — isn’t likely to change anytime soon.

“Major tax reforms tend to happen once in a generation, and they tend to need one party to control both the White House and both chambers of Congress. And even then, a big tax code change needs to be their priority. So, the earliest this could possibly happen again would be after the 2024 election, so call it 2025,” noted Michael Zezas, global head of fixed income and thematic research for Morgan Stanley.

For more news, information, and analysis, visit the Fixed Income Channel.