Fixed income investing outside of a tax-advantaged account has long been a struggle for many investors owing to the relative tax inefficiency of most bond ETFs.
Traditionally, the solution to this has been an allocation to bond ETFs holding municipal bonds, which are exempt from Federal (and in some cases, state) taxation.
Popular examples of these include the iShares National Muni Bond ETF (MUB) and the Vanguard Tax-Exempt Bond Index Fund ETF (VTEB), both of which charge low expense ratios.
However, one downside faced by both of these funds is a relatively high duration, a measure of interest rate sensitivity. Case in point, MUB currently sits at 6.5 years, while VTEB clocks in at 5.5 years.
An intermediate duration of 5.5 to 6.5 years would result in a 5.5% to 6.5% loss if interest rates rose by 1%, all else being equal. For lower-risk or older investors, this can be suboptimal.
To remedy this, Vanguard launched the Vanguard Short-Term Tax-Exempt Bond ETF (VTES) in March 2023 as a shorter duration counterpart to VTEB.
Let's break down this new ETF and take a look at what's under the hood.
VTES ETF strategy and holdings
The strategy employed by VTES is classic Vanguard indexing at its finest. The ETF tracks the S&P 0-7 Year National AMT-Free Municipal Bond Index via a sampling technique. As opposed to full replication, sampling ensures that VTES only selects a portion of the index. This helps keep costs low and avoid potentially illiquid issues, while still ensuring close tracking of the benchmark.
As of March 31, 2023, VTES holds 538 bonds with assets under management of $71 million. Unfortunately, since this is a new ETF, metrics such as yield to maturity and duration are not yet available. For now, we'll have to rely on its index as a proxy.
According to the factsheet for the S&P 0-7 Year National AMT-Free Municipal Bond Index, VTES would likely have a yield to maturity of 2.76% as of March 31, 2023, along with a modified duration of 2.37 years and a weighted average maturity of 3.1 years.
Historically, the S&P 0-7 Year National AMT-Free Municipal Bond Index has returned an annualized 1.27% total return over the trailing 10 years, while incurring a 10-year annualized standard deviation of just 0.59%, pointing to its historically low level of risk and return.
Comparing VTES and SUB
The closest competitor for VTES on the market is currently the iShares Short-Term National Muni Bond ETF (SUB).This ETF tracks the ICE (NYSE:ICE) Short Maturity AMT-Free US National Municipal Index. Thanks to its different index, VTES could potentially be a viable tax-loss harvesting partner for SUB.
VTES launched with an expense ratio of 0.07%, identical to SUB. Vanguard likely did this to remain competitive with VTES, given SUB's much older inception date of November 5, 2008, and much higher AUM of over $10 billion as of April 20, 2023.
In my opinion, I'm not sure that matching SUB's 0.07% expense ratio was sufficient to entice investors to make the switch to VTES. Despite Vanguard's stellar reputation, an investor holding SUB is unlikely to switch to VTES simply because the latter does not undercut the former in fees.
After all, SUB is currently the longer-tenured fund with higher AUM and greater trading volume. Why take the chance to switch around? As I mentioned earlier, I think most investors may keep VTES in their back pocket as a tax-loss harvesting pair. Then again, die-hard Vanguard fans might flock to it.
VTES: The Verdict
To me, the launch of VTES is a breath of fresh air after a year of wacky thematic ETF debuts. I think this ETF can serve as a core bond allocation for low-risk investors with a shorter time horizon, especially those in a higher tax bracket. Its 0.07% expense ratio is highly competitive and the ETF is ultimately backed by a key industry player with a strong history of investor advocacy and fee reductions.
This content was originally published by our partners at ETF Central.