An opportunity is emerging in the realm of tax-free bonds, potentially offering investors significant gains if approached with caution. Municipal bonds, cherished by high-income investors, provide interest income free from federal taxes. Additionally, they are exempt from state taxes if the investor resides in the issuing state, a feature that offers substantial savings in high-tax regions like New York and California, where top income tax rates reach 10.9% and 13.3%, respectively.
Retail investors have recently shown increased interest, with Vanguard’s Tax-Exempt Bond ETF (VTEB) attracting $1.9 billion in inflows over the past month alone. Year to date, the fund has experienced over $2.7 billion in flows. VTEB boasts a 30-day Securities and Exchange Commission yield of 3.87% and an expense ratio of 0.03%.
Understanding Duration and Its Impact
While the allure of tax-advantaged yields is undeniable, investors may miss opportunities if they focus solely on short-duration municipal bonds. These bonds have less price sensitivity to interest rate changes and typically have shorter maturities. While they offer solid yields when interest rates are high, they do not appreciate as much when the Federal Reserve reduces rates. Bond yields and prices are inversely related, with longer-duration issues showing greater price sensitivity to rate fluctuations.
“The crowd mentality that’s driven by fear is heading to the front end of the yield curve,” said Stephen McFee, senior portfolio manager at Vanguard. “They are running from that duration risk. The overlooked part of the market is the long-end part of the market.”
McFee, who also manages Vanguard’s Core Tax-Exempt Bond ETF (VCRM), which has an average stated maturity of 14.4 years and an average duration of 7.3 years, advocates for not neglecting the long end of the market. The fund offers a 30-day SEC yield of 4.07% with an expense ratio of 0.12%.
Strategic Approaches to Duration
Bank of America strategists have echoed the sentiment of adding duration to municipal bonds, anticipating a rally in the muni market both in the near term and throughout the year. According to Yingchen Li, a municipal research strategist at Bank of America, the market may not see the same yield spikes as earlier this year, even with the end of a 90-day reprieve on President Donald Trump’s tariffs.
In a June 27 report, Bank of America’s muni team recommended overweighting single-A and triple-B municipal bonds while maintaining a focus on duration exposure. However, this does not imply indiscriminate investment in the longest-dated municipal bonds. Active managers are focusing on the intermediate part of the muni bond curve, particularly the 3- to 7-year range, while managing duration carefully, according to Shannon Saccocia, chief investment officer of wealth at Neuberger Berman.
“While there’s some hesitation on duration, taking a little bit of it – especially that 3- to 7-year range – and given the attractive pricing right now, it’s not something to be overly concerned about,” Saccocia said.
Customizing Duration for Individual Needs
Investors who purchase individual municipal issues for a customized portfolio can work with advisors to determine the appropriate average duration. They can then hold through price fluctuations, waiting for maturity. Those utilizing mutual funds and exchange-traded funds benefit from liquidity and can access the market with fewer assets, though they will still experience price volatility.
Blair duQuesnay, a certified financial planner at Ritholtz Wealth Management, suggests that investors might consider pairing short-duration muni bond funds with long-duration counterparts to achieve a desired average duration.
“You would start with what average duration you want to have, and you blend the two,” duQuesnay explained. “The advisor needs to be aware of what strategy is used in each fund. But if you start with ‘What duration am I comfortable with?’ The ratio of the two funds is based on what you want this average duration to be.”
As the municipal bond market evolves, investors are advised to stay informed and work closely with financial advisors to tailor their strategies, balancing yield potential with risk management.
