Tax-Free Municipal Bonds: A Strategic Play Amid Market Fluctuations

An opportunity is emerging in the realm of tax-free bonds, offering potential outperformance for investors who navigate it wisely. Municipal bonds, cherished by high-income investors, provide interest income free from federal taxes. Additionally, they are tax-exempt at the state level if the investor resides in the issuing state, offering significant savings in high-tax states like New York and California, where top income tax rates reach 10.9% and 13.3%, respectively.

Retail investors have shown increased interest, as evidenced by Vanguard’s Tax-Exempt Bond ETF (VTEB), which has attracted $1.9 billion in inflows over the past month. Year-to-date, the fund has seen over $2.7 billion in flows. VTEB boasts a 30-day Securities and Exchange Commission yield of 3.87% and an expense ratio of 0.03%.

Understanding Duration and Yield Dynamics

While tax-advantaged yields are appealing, investors may miss out if they focus solely on municipal bonds with short durations, which are less sensitive to interest rate changes. Short-duration fixed income assets typically have shorter maturities, offering solid yields when interest rates are high. However, they do not experience as much price appreciation when the Federal Reserve reduces rates. Bond yields and prices are inversely related, and longer-duration issues tend to have greater price sensitivity during rate fluctuations.

According to Stephen McFee, senior portfolio manager at Vanguard, “The crowd mentality that’s driven by fear is heading to the front end of the yield curve. They are running from that duration risk. The overlooked part of the market is the long-end part of the market.” McFee advises against shunning the long end, where he sees current value.

“Don’t shun the long end. That’s where we see value now,” McFee stated.

McFee also manages Vanguard’s Core Tax-Exempt Bond ETF (VCRM), which has an average stated maturity of 14.4 years and an average duration of 7.3 years. The fund offers a 30-day SEC yield of 4.07% and an expense ratio of 0.12%.

Strategic Duration Management

Adding duration to municipal bonds has been a key strategy at Bank of America, where strategists predict a reacceleration in the muni market rally in the near term and throughout the year. Yingchen Li, municipal research strategist at Bank of America, noted in a June 6 report that the impact of tariffs is less shocking than earlier in the year. As a result, even when the 90-day reprieve on President Donald Trump’s steepest tariffs ends, bond yields may not spike as they did previously.

In a subsequent report, the Bank of America muni team expressed an overweight position on single-A and triple-B municipal bonds, maintaining their recommendation for increased duration exposure. However, this does not imply indiscriminate investment in the longest-dated municipal bonds. Active managers are focusing on the intermediate part of the muni bond curve, specifically the 3- to 7-year range, and are cautious with duration, according to Shannon Saccocia, chief investment officer at Neuberger Berman.

“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,” Saccocia explained.

Customizing Bond Portfolios

Investors who opt for individual muni issues to create a customized portfolio can work with advisors to determine the appropriate average duration. They can then ride out price fluctuations while awaiting maturity. For those utilizing mutual funds and exchange-traded funds for their muni bond needs, the liquidity offered is advantageous, although price fluctuations are inevitable.

In such cases, investors might consider pairing a short-duration muni bond fund with a long-duration counterpart, as suggested by Blair duQuesnay, a 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,” duQuesnay advised. “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.”

Looking Ahead

The strategic management of duration in municipal bonds offers investors a pathway to balance yield and price appreciation amid fluctuating interest rates. As market dynamics evolve, the insights of experts like McFee, Saccocia, and duQuesnay provide valuable guidance for navigating this complex landscape. Investors are encouraged to engage with financial advisors to tailor their bond portfolios to their risk tolerance and financial goals, ensuring a well-rounded approach to tax-free yield opportunities.

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