Vanguard plans to launch a new short-term municipal bond ETF in 2023

Municipal bond ETF - what we know so far 

The press release contained comments from Daniel Reyes, head of the Vanguard Portfolio Review Department. Reyes noted that:

"The new Short-Term Tax-Exempt Bond ETF has been thoughtfully constructed for tax-sensitive investors with a short time horizon and low risk tolerance, in complement to our broad range of municipal bond strategies."

Like many of Vanguard's fixed income ETFs, VTES will be passively managed, tracking the S&P® 0-7 Year AMT-Free Muni Bond index. The estimated expense ratio for VTES will likely sit around 0.07%. 

The main appeal of VTES is its tax-efficiency. With corporate bond ETFs, most of the interest paid out is taxable at the ordinary income rate, which can be quite high depending on your income bracket. Treasury bonds might be exempt from state tax, but not federal tax. Aggregate bond ETFs sit somewhere in the middle.

The most tax-efficient bond ETFs are those holding municipal issues. Income from municipal bond funds is exempt from federal taxes and can be exempt from state and local taxes if held by a resident of the state or city that issued them, hence their greater tax-efficiency. ETFs like VTES allow investors to access a portfolio of municipal bonds easily with a single ticker.

VTES versus VTEB

I spoke with Jessica Schifalacqua from Vanguard's public relations department, who was able to provide a more in-depth overview of VTES versus VTEB:

• VTEB is diversified across short-, intermediate-, and long-term maturities, while VTES will focus on short-term municipal issues.
• VTES will follow the same overall index rules as VTEB, with the primary difference being the shorter maturity band of seven years.
• VTES will cost an estimated expense ratio of 0.07%, slightly higher than VTEB which currently costs 0.05%. 

VTEB currently has an average maturity of 13.6 years, with an average duration of 5.8 years. All else being equal, a 1% increase in interest rates will cause the net asset value, or NAV, of VTEB to fall by 5.8% years. VTES will have a shorter maturity and duration, and thus lower interest rate sensitivity. 

If VTEB's current holdings are any indication of VTES' eventual composition, there will likely be a sizable allocation to AAA (21.50%), and AA (55.80%) rated bonds. Anything above BBB is considered investment grade, and municipal bonds are as low-risk as it gets outside of Treasurys. 

Who is VTES suitable for?

Echoing Reye's comments, I think VTES is best suited for older investors with a lower risk tolerance who have maxed out their tax-advantaged accounts. With VTES, these investors can now hold higher fixed income allocations in a taxable account with better tax-efficiency and lower interest rate risk.

2022's rising interest rate environment taught many older investors that an allocation to intermediate-duration bonds could be just as volatile and risky as equities. Shorter duration ETFs like VTES can help these investors better match the risk-return profile of their bond allocation to their time horizon. 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.