Three Cs that can make your active municipal bond investments sparkle

Just as we do in the rest of our nearly $200 billion¹ active municipal mutual fund complex, we apply the three Cs in our first two active muni ETFs: Vanguard Core Tax-Exempt ETF (VCRM) and Vanguard Short Duration Tax-Exempt ETF (VSDM), to maintain consistent income and balance taxable portfolio risk. These new ETFs are designed to help your clients work toward their investment goals with confidence and precision.

Let’s examine the facets of the three Cs more closely.  

One of our strengths is research, which we use to identify issuers with strong fundamentals or those for which higher yields compensate investors for the extra risk taken. From a credit perspective, we see ample opportunity in muni bonds.

High-income U.S. investors dominate the tax-exempt market, where they tend to buy bonds individually or as part of separately managed accounts. Those investors gravitate to AAA bonds in order to minimize credit risk. But that behavior means that lower-rated bonds can often offer better-than-expected yield, especially on the shorter end of the curve.

• We think the best cut for municipal credit spread is in bonds rated single-A and below.
• Research and security selection can add value at any credit level of the muni market. 

Carry can encompass a few strategies. Most simply, it can mean to out-yield a benchmark, often by adding beta from credit or duration. Carry also involves optimizing positions at different points in the yield curve based on roll-down—the increase in value of a bond as it approaches maturity.

• Amid the current interest rate outlook, we expect carry to play an important income-generating role in our portfolios. 

When interest rates change, a bond’s price can fluctuate. We measure this sensitivity to interest rate changes as duration. But for municipal bonds with call options, duration can be far from consistent; the extent to which duration can change for a given bond is referred to as convexity.

Here’s an example. Let’s say a bond issuer’s option to call a bond early goes out-of-the-money as market yields rise above the bond’s coupon level (why would an issuer want to refinance debt at a higher rate?). The duration for this security could rise from eight to 15 years as market trading adjusts from an expected life of 10 years (call date) to that of 30 years (stated maturity).

It’s difficult to measure and manage this risk for tens of thousands of bonds, which is why many municipal investors (direct retail, SMAs, even many asset managers) usually allocate to just avoid these risks as much as they can. The resulting mispricing of convexity leads to instances in which we can often construct a portfolio with benchmark-relative alpha potential without the downside.

In sum, a callable municipal bond’s sensitivity to interest rate changes can rise (or fall) as market yields take large swings, especially as market yields cross over (or under) the coupon rate.

• In a market with thousands of callable bonds (roughly 80% of the market), convexity becomes a complex but meaningful factor in valuations. Only a sophisticated active manager can model forward pricing and act on opportunities.
• Our team has decades of experience analyzing convexity so that it can be used as a key element in not only managing duration risks but also extracting value.
• It’s a primary performance driver for intermediate and long muni funds such as VCRM. 

Like a savvy diamond buyer uses their own knowledge and awareness to help find the best stone for the best price, we use our experience with credit, carry, and convexity to find gems for Vanguard’s muni fund investors.

Our job as an active manager is to use the flexibility of these levers to take advantage of opportunities as they arise, even as we do the traditional work of analysis across sectors, regions, and issuers. 

Now we have two new gems to add to our offering: our first active muni ETFs.  

VCRM is a broadly diversified ETF, with an investment mandate that allows us to invest across the full yield curve and across all sectors. That empowers us as active managers to use all the tools at our disposal—even as we maintain the risk management that clients have come to expect from Vanguard.

• VCRM can serve as the long-term, tax-smart centerpiece of a client’s taxable portfolio. 

We introduced VSDM as well to serve muni clients who prefer a lower level of interest-rate risk. However, we can invest in intermediate-term tax-exempt bonds for that ETF if we keep the overall portfolio’s duration on the short end.

• VSDM can help clients with low risk tolerance participate in the muni market—or help those with cash needs in the foreseeable future.

Vanguard has managed active muni bond funds for nearly 50 years, and we have a long history in index funds and ETFs. Combining these capabilities is natural evolution for our team. 

Vanguard Core Tax-Exempt Bond ETF (VCRM)

Vanguard Short Duration Tax-Exempt Bond ETF (VSDM)