The Vanguard Tax-Exempt Bond ETF (NYSEARCA:VTEB) is a simple municipal bond index ETF investing in tax-free, investment-grade munis. VTEB's holdings are all safe, high-quality securities, but the fund's 1.8% yield is quite low, and prospective returns are not all that much higher. VTEB is appropriate only for the most conservative income investors and retirees. For most others, higher-yielding tax-free municipal bond funds are a better choice. BlackRock has a suite of municipal bond CEFs, most of which are fantastic investments. Of these the BlackRock Municipal Income Trust II (BLE) currently trades with the largest discount to NAV, 10.3%, and yields 6.7%. For investors wishing to avoid CEFs, the VanEck Vectors High Yield Muni ETF (HYD) is a good choice, and yields 3.9%.
VTEB is a municipal bond index ETF. It tracks the Standard & Poor’s National AMT-Free Municipal Bond Index, a tax-free, investment-grade, municipal bond index. It is a relatively simple index, investing in all relevant securities meeting a basic set of liquidity, size, maturity, credit rating, and tax-exempt status criteria. Taxable bonds are specifically excluded, as are bonds with non-investment grade credit ratings.
VTEB's underlying index is quite broad, which results in an incredibly well-diversified fund, with investments in thousands of securities, and with exposure to most relevant states and issuers. Diversification reduces portfolio risk and volatility, and is a significant benefit for the fund and its shareholders.
VTEB exclusively invests in investment-grade bonds, with strong credit ratings. The fund's holdings sport an average credit rating of AA, indicative of high-quality issuers with no material, current financial difficulties.
VTEB's high-quality holdings ensure that risks are low, as are probabilities of default, and losses during downturns and recessions. VTEB suffered losses of less than 1.0% during 1Q2020, the onset of the coronavirus pandemic, and the most recent downturn. These are incredibly low losses, but in-line with those of most broad-based bond indexes, and significantly worse performance than treasuries. Still, losses are quite low, and a benefit for the fund and its shareholders.
VTEB's diversified, high-quality, low-risk holdings are a significant benefit for the fund and its shareholders, and a major component of its investment thesis. As such, the fund is clearly better suited for more risk-averse, conservative investors, for whom capital preservation is paramount.
Safe, high-quality bonds generally carry low yields, and VTEB's underlying holdings are no exception. The fund itself only yields 1.8%, a low amount in an absolute sense, and the second lowest yield in its peers group, only higher than treasuries.
On a more positive note, VTEB's yield is tax-free, while the yield on most bond funds is taxable. Investing in VTEB means tax savings for most investors, subject to personal income levels, and dependent on where the fund is bought (401k, personal portfolio, etc.). Depending on these and other factors, VTEB's tax-exempt dividends might be a better deal than the nominally higher taxable dividends offered by other funds. Nuveen provides investors with a simple infographic which helps investors compare tax-exempt yields with taxable yields depending on their tax rate, which might be of use to readers.
VTEB's dividend yield is quite low, but it should see some growth as the Federal Reserve continues to hike rates. Some of these hikes have already occurred, so some of said growth is already baked-in. It is not trivially easy to precisely estimate a fund's expected dividend growth, but there are two metrics which are of some use. VTEB currently sports a yield to maturity, a forwards-based measure of a fund's expected total returns, of 2.8%, quite a bit higher than the fund's 1.8% dividend yield. Some of these returns are due to expected capital gains from higher bond prices as these recover, but some are from increased income, which should result in higher dividend yields moving forward. VTEB also sports a 2.9% SEC yield, a measure of the income generated by the fund's holdings in the past 30 days. VTEB's SEC yield is also quite a bit higher than its dividend yield, a sign that the fund's dividend should see some growth moving forward.
Notwithstanding the above, VTEB's yield is quite low and, I'm confident, a deal-breaker for many investors. As mentioned previously, both BLE and HYD, and many other funds, have similar holdings to VTEB, but much greater yields. These two funds are also riskier than VTEB, but risks are not all that high on an absolute basis.
Bond funds are generally income vehicles, whose returns are almost entirely dependent on their income and dividends, and VTEB is no exception. The fund has achieved annual returns of 2.0% since inception close to seven years ago, a very similar figure to its 1.8% yield, slightly higher as yields were somewhat higher in the past. Returns have, however, materially worsened during the past year, as rising rates and bearish market sentiment has caused a broad bond sell-off. VTEB's returns are about average for a broad-based bond fund, and not materially different from those of its peers.
Moving forward, and as previously mentioned, VTEB's total returns should roughly match its yield to maturity of 2.9%. Future expected returns are somewhat higher than past returns, as interest rates have risen, and as bond prices are quite low at the moment.
In any case, although the fund's performance is not materially weaker than that of its peers, past and expected returns are quite low on an absolute basis. VTEB's investors will almost certainly earn little in dividends and capital gains moving forward, a significant negative for the fund and its shareholders. In my opinion, more conservative, risk-averse investors might be willing to overlook these issues due to the fund's safe, high-quality holdings, but others, probably most, might not be so willing. For these investors, higher-yielding municipal bonds like BLE and HYD are more appropriate investments, in my opinion at least.
VTEB is a simple municipal bond index ETF investing in tax-free, investment-grade munis. VTEB offers investors safe, high-quality holdings, but a low 1.8% yield. The fund might make sense for more conservative investors and retirees, but those looking for strong yields and prospective returns should look elsewhere.
Profitable CEF and ETF income and arbitrage ideas
At the CEF/ETF Income Laboratory, we manage ~8%-yielding closed-end fund (CEF) and exchange-traded fund (ETF) portfolios to make income investing easy for you. Check out what our members have to say about our service.
This article was written by
Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.
I provide my work regularly to CEF/ETF Income Laboratory with articles that have an exclusivity period, this is noted in such articles. CEF/ETF Income Laboratory is a Marketplace Service provided by Stanford Chemist, right here on Seeking Alpha.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.