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With tax rates likely on the rise in the near future in order to pay for the country’s surging deficit, municipal bond investing looks to grow increasingly important. That is because these securities pay interest that is free from federal income tax, and for many in-state bonds in some states, free from state and local income taxes as well. Thanks to this, many investors in high tax brackets can see attractive levels of after-tax returns when compared to non-exempt securities, making them crucial parts of many high net worth investors’ portfolios.
Beyond this yield benefit, many are likely to see the importance of munis from a diversification perspective as well. In fact, according to research from State Street, municipal bonds move almost independently of both Treasury bonds and U.S. stocks (correlations of -0.07 and -0.01, respectively, over the past ten years) and have just a modest correlation with corporate securities, coming in at 0.65. With both this diversification and potential yield benefit, it is easy to see why many investors are flocking to this corner of the investing world for some of their bond exposure (see Go Local With Emerging Market Bond ETFs).
Yet, beyond broad munis, there is a special subset of the sector that many investors have likely overlooked, the VRDO market. In this corner of the municipal world, bonds have variable rates which are reset on a weekly basis, making them unlike their fixed rate peers in the muni bond market. This distinction gives VRDOs an extremely low duration and virtually no interest rate risk. While this is a small issue now, it could become an important factor in the years ahead should the Fed be forced to move rates up to more historical levels. However, the safety of this is offset by the lower yield that investors receive, suggesting that no one type of security will always be better for every investor (see Do You Need A Floating Rate Bond ETF?).
Yet, for those that are intrigued by the low duration securities in the muni form, there are currently two ETFs that give access to the space. Both of these ETFs track the VRDO market and could be ideal for investors seeking to reduce duration, or for those looking to cycle into muni bonds should tax rates surge in the coming years. Below, we take a closer look at the options investors have in this corner of the market in order to highlight some of the key differences between the two funds in this intriguing space:
SPDR Nuveen S&P VRDO Municipal Bond ETF ( VRD - ETF report )
This ETF seeks to replicate, as closely as possible, the price and yield performance of the S&P National AMT-Free Municipal VRDO Index. To be included in the index, a security must be issued by a state or local government or an agency such that interest on the security is exempt from U.S. federal income taxes. Additionally the component securities must be priced at par and have a minimum par amount of $10 million. Investors should also note that securities are of high quality as well; components must be rated A-3, VMIG-3 or F-3 or higher by one of the following statistical ratings agencies: S&P, Moody’s or Fitch, respectively, and have a maturity of greater than or equal to one month (see Convertible Bond ETFs Head-To-Head).
VRD holds 41 securities in total, and charges investors just 20 basis points a year in fees for its services. Top state allocations go to New York (19.1%), Texas (11.7%), and Pennsylvania (7.6%) with the vast majority maturing in at least 15 years from now. In terms of yield, the product pays out just 0.45% but this turns into 0.69% in taxable equivalent yield for those in the top bracket. While this may not seem like much, it is important to remember that there is virtually no duration risk as the product has a seven day reset for its payouts. In terms of capital appreciation, the fund has seen choppy trading over the past year but it has gained close to 0.3% in the past 52 weeks, suggesting that it is a pretty low risk option in the space.
PowerShares VRDO Tax-Free Weekly Portfolio ( PVI - ETF report )
For another way to play the muni market, investors can always try out PVI, which tracks the Bloomberg US Municipal AMT-Free Weekly VRDO Index. This benchmark consists of about 50 securities from around the country, all of which have interest rates that are reset weekly and provide investors with tax-exempt income. This strategy of holding a slightly bigger basket—as well as the first mover advantage—has certainly paid off for PVI as the fund has amassed close to half a billion in assets since its launch. This greater asset base looks to give the fund a much more robust trading volume which could help to keep total costs low in spite of PVI’s higher expense ratio of 25 basis points (read Ten Best New ETFs Of 2011).
In terms of individual holdings, the product has the heaviest exposure to securities in the Northeast—specifically NY and NJ—as well as Texas. The product also has a varied maturity breakdown with close to 40% of the securities maturing in less than 15 years from now. Once again, this doesn’t matter in terms of duration risk as the product sees rates reset every seven days, much like its SPDR counterpart. However, thanks to the inclusion of far more higher-rated securities, the yield is lower for PVI, coming in at 0.39% in 30 Day SEC terms, or roughly .6% in after tax equivalents. Lastly, the fund also has performed slightly worse over the past 52 weeks, gaining just 0.04% in the time period, suggesting it is even less volatile than the other VRDO ETF in the space.
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