Scoop up tax-free yield and keep price fluctuations in check with these bonds

CNBC

4 days ago

An opportunity is taking shape within the world of tax-free bonds – and it may offer investors some outperformance if they're careful. Municipal bonds are beloved by high income investors as they spin off interest income that's free of federal taxes. They're also tax-exempt on a state basis if the investor resides in the issuing state – a feature that can provide meaningful savings in high-tax locales like New York and California, where top income tax rates are 10.9% and 13.3%, respectively. Retail investors have also been jumping into the space as of late, with Vanguard's Tax-Exempt Bond ETF (VTEB) scooping up $1.9 billion in inflows over the past month. Year to date, the fund has seen more than $2.7 billion in flows. VTEB has a 30-day Securities and Exchange Commission yield of 3.87% and an expense ratio of 0.03%. Even as tax-advantage yield may be attractive, investors may be missing out if they stick solely with muni bonds that are short in duration – meaning that they have less price sensitivity to changes in interest rates. Fixed income assets with short duration also tend to have shorter maturities. The upshot is that they offer solid yield when interest rates are high. However, they don't see as much price appreciation once the Federal Reserve dials back rates. Bond yields and their prices are inversely related, and longer-duration issues tend to have the greatest price sensitivity when rates fluctuate. "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." "Don't shun the long end. That's where we see value now," he said. McFee is also portfolio manager on Vanguard's Core Tax-Exempt Bond ETF (VCRM) , which has an average stated maturity of 14.4 years, but an average duration of 7.3 years. The fund has a 30-day SEC yield of 4.07%, and an expense ratio of 0.12%. A sensible approach to managing duration Adding duration to municipal bonds has also been the rallying cry at Bank of America, where strategists have been calling for a reacceleration in the muni market rally both near term and in the rest of the year. One of the reasons behind that is because headlines around tariffs aren't as shocking as they were in April – and that means that even when the 90-day reprieve on the steepest of President Donald Trump's tariffs ends next week, bonds may not see yields spike the way they did earlier this year, according to Yingchen Li, municipal research strategist at Bank of America, in a June 6 report. In a June 27 report, the Bank of America muni team said it's overweight single-A and triple-B municipal bonds, and it's sticking with its suggestion that investors add duration exposure. That doesn't necessarily mean to load up indiscriminately on the longest-dated municipal bonds, however. Active managers seem to largely be focusing on the intermediate part of the muni bond curve – that is, the 3- to 7-year part of the range – and being careful with duration, said Shannon Saccocia, chief investment officer - wealth for Neuberger Berman. This intermediate duration offers yield and the opportunity for price appreciation – but the swings aren't as dramatic as what would likely show up on the issues with longest durations. "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," she said. "If you're looking under the hood, and you're in a double-digit duration, maybe you'll want to ask some questions, but active managers are managing that duration risk pretty well," Saccocia added. Customizing duration Investors who snap up individual muni issues for a customized portfolio can work with an advisor to determine the average duration they should have – and they can sit tight through fluctuations in prices because they are waiting for maturity. Those who use mutual funds and exchange traded funds to address their muni bond needs, however, have the benefit of liquidity — and they can get exposure to the space with fewer assets. Still, they'll see plenty of price fluctuations in the meantime. In that case, investors may want to consider working with an advisor to pair a short-duration muni bond fund with a long-duration counterpart, said Blair duQuesnay, certified financial planner at Ritholtz Wealth Management in New Orleans. "You would start with what average duration you want to have, and you blend the two," she said. "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."