Why We Like Vanguard Tax-Exempt Bond ETF

Key Morningstar Metrics for Vanguard Tax-Exempt Bond ETF

• Morningstar Medalist Rating: Gold
• Process Pillar: Above Average
• People Pillar: Above Average
• Parent Pillar: High

Vanguard Tax-Exempt Bond ETF VTEB offers a broad portfolio of investment-grade municipal bonds with an attractive price tag.

The exchange-traded fund tracks the S&P National AMT-Free Municipal Bond Index, which captures a broad slice of the tax-exempt, investment-grade muni-bond market. Eligible issues must have at least $25 million outstanding in face value and come from a deal of at least $100 million. The index also excludes several riskier sectors such as tobacco and housing, as well as conduit bonds and bonds issued by U.S. territories. It weights selected bonds by their market value, subject to an issuer-level weight cap.

Issuance activities in the muni market concentrate in a few large states, and the ETF’s portfolio reflects this. As of November 2023, it allocated more than 40% of its assets to bonds from issuers in New York (20%), California (15%), and Texas (8%). Focusing on bigger issuers keeps the ETF in more liquid corners of the market and helps alleviate trading costs and capacity issues.

General-obligation bonds account for nearly one third of the portfolio, a sizable overweight compared with the average peer in the muni-national intermediate Morningstar Category. These bonds tend to carry higher credit ratings than revenue bonds, as they are backed by the general creditworthiness and taxing power of the municipalities instead of a specific project.

This sector tilt also translates to a conservative credit risk profile for the ETF. It often parks about 70% to 80% of its assets in bonds rated AA and above. By comparison, this figure hovers around 45% for the category average. This high-quality tilt has shielded the ETF from the worst of credit shocks but can leave it lagging when credit spreads tighten.

A low annual fee is one of this ETF’s most prominent advantages. In the long run, its razor-thin expense ratio of 0.05% should help it stay ahead of category peers.

Vanguard Tax-Exempt Bond ETF: Performance Highlights

From its 2015 inception through November 2023, the ETF outperformed the category average by 38 basis points annualized with slightly higher volatility. Over the same period, its risk-adjusted return (as measured by Sharpe ratio) was comparable to the category average. Much of this outperformance came from its razor-thin expense ratio and broad scope.

The ETF’s quality tilt better cushioned its performance during credit shocks than its average category peer. It outpaced the category average by 61 basis points during the coronavirus shock in 2020 from Feb. 20 through March 23. Similarly, it lost 37 basis points less than the category average during the high-yield selloff in the last quarter of 2018. On the other hand, the ETF will miss out when credit spreads tighten. It lagged the category average by 31 basis points during the recovery period from late March through December 2020 when spreads rapidly compressed.

The ETF’s slightly longer duration can cause modest underperformance when interest rates rise. It lagged the category average by 17 basis points throughout the first 10 months of 2018 as Treasury yields spiked. However, it held up better than the category average in the interest-rate-driven meltdown in 2022 as recessionary fears caused credit spreads to widen.