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A Broad and Strong Municipal Bond Fund

Morningstar logo Morningstar 2/20/2019 Daniel Sotiroff

Historically, gaining access to municipal bonds through an index strategy has been difficult because the muni bond market is much more fragmented and expensive to trade than other fixed-income markets. But process improvements over the past several years, combined with a deeper knowledge of the market, have provided asset management firms like Vanguard with an advantage. An index-tracking fund like  Vanguard Tax-Exempt Bond ETF VTEB now features exceptionally low tracking error, making it a solid choice for exposure to the broader municipal-bond market.

VTEB offers broad exposure to investment-grade municipal bonds and is one of the cheapest funds in the muni national intermediate Morningstar Category, earning a Morningstar Analyst Rating of Silver.

The fund tracks the S&P National AMT-Free Municipal Bond Index. The interest its holdings pay is not subject to federal income tax. As a result, these bonds typically offer lower pretax yields than taxable bonds and are attractive only to investors in the highest tax brackets. The managers use a statistical sampling approach to track this bogy as it isn't practical to own every bond in the index.

The portfolio weights its constituents by market value, so its holdings skew toward the largest debt-issuing states. At the end of December 2018, the fund had greater exposure to California and New York than the category average. It collectively allocated one third of its assets to these states, while the average fund in the category had a 16% stake. Both these states have relatively high credit ratings, so higher-than-average exposure doesn't hurt the fund's overall credit risk.

The portfolio's average credit rating is higher than the category norm. Almost 80% of its assets are invested in securities rated AA or above. Most of its peers take greater credit risk, though the fund takes slightly more interest-rate risk than the category average. This means that the fund's value could decline by a modestly higher amount than the category average when the yield curve experiences an upward shift.

The fund has a short track record, and the managers have stayed close to the target index over its life. From its launch in August 2015 through December 2018, the fund's total and risk-adjusted returns outperformed nearly three fourths of its peers. It features one of the lowest fees in the category, which should continue to provide a durable advantage.

Fundamental View

State and local governments issue municipal bonds to finance a variety of projects such as transportation infrastructure and education. To reduce financing costs for local governments, the federal government exempts the interest payments on these securities from federal taxes, making them ideal for investors in high tax brackets. At the end of December 2018, the fund's 4% tax-equivalent SEC yield exceeded the Bloomberg Barclays U.S. Aggregate Bond Index's 3.3% SEC yield. This tax-equivalent yield is the yield a taxable-bond fund would need to offer to equal the muni-bond fund's tax-exempt yield for an investor in the highest federal tax bracket. While muni bonds' interest is exempt from federal taxes, investors may still need to pay state taxes on that income, particularly if the bonds are issued outside their home state.

Market-value weighting offers advantages such as transparency and low transaction costs, as larger bonds tend to be cheaper to trade. However, it also pulls the portfolio toward the most debt-ridden states and localities. The fund's stakes in California and New York, which accounted more than one third of the portfolio as of December 2018, were twice the category norms.

The portfolio's high-credit-quality holdings help mitigate its geographic concentration risk. Bonds rated AA or higher make up roughly 80% of the fund's assets. In contrast, the typical muni intermediate-bond fund invests about 40% of its portfolio in the AAA and AA buckets. This fund should outperform during down markets when credit spreads widen, but it will also likely lag in strong markets when credit spreads tighten. The fund's average effective duration has historically been longer than the category average, making it more sensitive to interest-rate changes. But this can change over time.

The fund has produced a decent return thanks to its durable cost advantage. From its launch in August 2015 through December 2018 it beat the category average by 24 basis points annually, which was better than two thirds of its competitors. Its risk-adjusted performance over this period, as measured by Sharpe ratio, also landed in the top third of the category.

Portfolio Construction

The strategy earns a Positive Process Pillar rating because it accurately represents its target market, promotes low turnover, and skews toward the most-liquid securities, which keeps transaction costs low.

The fund employs representative sampling to track the S&P National AMT-Free Municipal Bond Index. This broad benchmark provides exposure to the U.S. investment-grade tax-exempt muni-bond market, but it excludes bonds subject to the Alternative Minimum Tax. Bonds must be a constituent of a deal that originally amounted to at least $100 million at offering and have a minimum par value of $25 million. In addition, each bond must have at least a calendar month and a day until maturity or call date to be included.

The index weights its constituents by market value, which mitigates turnover. This technique also emphasizes the most indebted issuers, but the index's emphasis on high credit quality mitigates the risk of default. The fund excludes bonds issued in U.S. territories, such as Puerto Rico. These bonds account for a small fraction of the muni bond universe, so excluding them doesn't hurt the fund's diversification. The index rebalances its holdings at the end of each month.

Fees

Vanguard offers this fund through two low-cost share classes, so it earns a Positive Price Pillar rating. In November 2018 Vanguard closed the Investor share class and lowered the investment minimum on the Admiral share class to $3,000 from $10,000 ($3,000 was the minimum for the outgoing Investor share class). The Admiral shares and the ETF both charge 0.09%, which ranks among the lowest fees in the category. Admiral shares also have an additional 0.25% purchase fee. The ETF lagged its target index by 8 basis points annually over the trailing three years through December 2018, an amount comparable to its expense ratio.

Alternatives

Bronze-rated  iShares National Municipal Bond ETF MUB tracks the same index as VTEB and dropped its expense ratio in 2018 to 0.07% from 0.25%. The second-largest is Neutral-rated  VanEck Vectors AMT-Free Intermediate Municipal ETF ITM (0.24% expense ratio). Both funds take comparable credit and interest-rate risks.

Longer-duration municipal bonds can offer higher returns. Investors looking for exposure to these bonds might consider Bronze-rated  SPDR Nuveen Bloomberg Barclays Municipal Bond ETF TFI (0.23% expense ratio). Because of its longer duration, this fund is in the muni national long category. Virtually all this fund's assets are invested in bonds rated AA or higher, and it offers a higher yield than VTEB.

 Fidelity Intermediate Municipal Income FLTMX (0.36% expense ratio) is a solid actively managed alternative that carries a Gold rating. It is run by a strong investment team and sports an impressive long-term track record. This fund has a shorter duration of five years, making it slightly less sensitive to interest-rate movements.

 

© Provided by Morningstar, Inc.

 

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