In recent discussions surrounding bond investments, a notable trend has emerged: the perception of tight spreads within the bond market. Investors have been grappling with a lack of adequate compensation for the increased risk associated with bonds beyond the government-backed U.S. Treasury securities. However, Steve McFee, a seasoned portfolio manager at Vanguard with a focus on municipal bonds, articulates a different perspective. He emphasizes that municipal bonds, which relate to local governments, offer a more compelling investment value compared to corporate credits, thanks to their attractive pricing and distinct tax benefits.
Unlike many corporate bonds that have responded swiftly to shifting market conditions, municipal bonds have lagged, leading McFee to suggest that there remains significant potential for growth in this sector. Vanguard’s recent introduction of two new municipal bond ETFs—the Core Tax-Exempt Bond ETF (VCRM) and the Short Duration Tax-Exempt Bond ETF (VSDM)—reflects this belief in the attractiveness of municipal bonds. Priced with a management fee of just 0.12%, these actively managed funds aim to encourage investors to capitalize on opportunities within the municipal bond market.
Municipal bond funds primarily invest in fixed income securities issued by state and local governments or associated entities. The standout feature of these funds is the tax exemption on the income they generate, providing an inherent advantage when compared to other bond types. Investors are encouraged to calculate the tax-equivalent yield when evaluating municipal bonds. For example, an investor facing a 32% income tax rate would need to seek out a taxable bond yielding approximately 4.41% to match the income from a municipal bond yielding 3%.
The relative safety of municipal bonds, particularly since the onset of the COVID-19 pandemic, has aided their attractiveness. An influx of federal assistance and stimulus measures helped to bolster governmental budgets nationwide. Now, several years removed from those peak stimulus periods, McFee maintains that municipal bonds remain on solid ground. While there has been some normalization post-stimulus, the fundamentals of this sector continue to exhibit resilience and promise.
Among his insights, McFee highlights a compelling opportunity in municipal bonds rated BBB. While these bonds are classified as investment-grade, they present a slightly higher risk than their AAA-rated counterparts. For investors willing to navigate this additional risk, BBB-rated munis offer the potential for higher yields without straying too far into the realm of high yield or junk bonds.
The landscape for municipal bonds has become increasingly favorable as we progress into 2024. In recent weeks, major index funds such as the iShares National Muni Bond ETF (MUB) and the Vanguard Tax-Exempt Bond ETF (VTEB) have collectively attracted over $2.2 billion in new investments, with year-to-date inflows surpassing $6.7 billion. This trend signals a substantial increase in interest in municipal bonds, reflecting their perceived value in the current economic climate.
Market Trends and the Future of Municipal Bond Investing
Returns for key municipal bond ETFs, like MUB and VTEB, have been commendable, with both yielding approximately 1.7% year to date, outpacing the 1.6% return of the iShares Core U.S. Aggregate Bond ETF (AGG). The positive sentiment surrounding municipal bonds has not gone unnoticed; various esteemed asset managers—including State Street, Goldman Sachs, and American Century—have all recently diversified their offerings with new municipal bond ETFs launched within the latter half of 2024.
The current investment climate for municipal bonds presents a compelling case for investors to reconsider their strategies. As McFee indicates, the municipal market is primed for growth with ample opportunities, particularly in areas of the market that may have previously been overlooked. With solid fundamentals supporting the outlook for municipal bonds, investors could find an ideal avenue to explore tax-advantaged, lower-risk investments in a landscape that continues to evolve.