An episode from Vanguard’s Investment Commentary podcast series
Akweli Parker: Hello, and welcome to Vanguard’s Investment Commentary Podcast series. I’m Akweli Parker. In this month’s episode, which we’re recording on August 25, 2016, we’re taking a look at the fixed income market and, in particular, what’s behind growing investor interest in municipal bonds. To talk about that, I’m joined by Edward Saracino, a senior product manager for municipal bonds and money market funds in Vanguard’s Portfolio Review Department. Ed, welcome to the program.
Edward Saracino: Great to be here, Akweli.
Akweli Parker: Ed, could you start us off by quickly painting a picture for us of the team that you work with and what they’re responsible for?
Edward Saracino: Yeah, I partner with a 40-person municipal bond team. We run roughly between $160 billion and $170 billion in assets under management, and we run both municipal bond funds and municipal bond money market funds with average expense ratios ranging anywhere from 12 basis points to, for some of our state-specific funds, to roughly 16 basis points.
So the operating structure that Vanguard has and the ability to scale that $160 billion allows us to be able to run these funds very efficiently. There is an expense ratio advantage that allows investors to keep more of the returns. For example, Vanguard Intermediate-Term Tax-Exempt Fund is 12 basis points. The Lipper peer-group average is 80 basis points. And also the fact that, when we’re going into the marketplace and being able to purchase bonds, we can do that very efficiently as well.
So you know and our Vanguard clients know that costs are a very important factor in determining potential outcomes for your investment and even more so in the municipal bond space. And the reason why that’s the case is, if I think about a distribution of potential outcomes for a municipal bond investor, it’s relatively modest. Now, if you think about that relative to equities, that distribution can be wide. And if I think about where current yields are, yields are pretty low. So costs are a very important factor.
So, you know, the expense ratio advantage that we have and the fact that our team can implement very efficiently has been a great competitive advantage for us.
Akweli Parker: Those are some great points. We often read about so-called star fund managers who are individually responsible—or at least that’s how they’re portrayed in the media—for what goes into their fund’s portfolios and for their portfolios’ success or lack thereof. And when those stars leave their firms, they often take with them their expertise and client assets. Now, when you and I spoke offline a little bit earlier, you told me about a different fund management process in place at Vanguard. Can you talk about that structure and any possible advantages it might have?
Edward Saracino: Yeah, definitely. So, first, I want to take a real quick step back and just talk about our pure philosophy that we have within our portfolios; and what we’re trying to deliver is style-pure, diversified exposure to our clients. And we also want them to know what they’re going to get.
So if they’re investing in Vanguard Intermediate-Term Tax-Exempt Fund, they’re not going to wake up tomorrow, and it’s going to be a short-term fund, or it’s going to be a long-term fund. We’re not going to be taking any unnecessary credit risk within the portfolio.
And the reason why we do that is, you know, we know our clients well; and, ultimately, they think about municipal bonds as a key part of their portfolio, but it’s not an area of the market where they want to start taking significant risk. There’s always other segments of your portfolio where you can take risk; but within the municipal market, they want very predictable returns.
So we implemented what we refer to as a hub-and-satellite structure. It’s a combination of all members of our group. So, back to your point earlier, we think of it as more of a sum of the parts rather than any one individual that’s running any of our funds at any point in time.
And, the way that structure works is the underlying satellites are going to be embedded with the members of the team. So that’s where you start getting your technical expertise. So the satellites are a combination of portfolio managers, which provide a broader, longer-lens view; traders who are experts on their segment of the market and pricing levels and how to execute efficiently; and you also have credit analysts as well, and they’re doing the bottom-up fundamental research to determine the creditworthiness of all the underlying issues.
So the reason why this is important and the reason why we implemented this structure is that we have that deep expertise, and we’re taking advantage of everybody to be able to provide returns for our clients.
Akweli Parker: Got it. Industrywide, municipal bond funds have been experiencing some pretty astonishing positive cash flows. What are some of the major factors that have been driving this phenomenon?
Edward Saracino: Yeah, so there’s been a lot of cash flows coming into municipal bonds. So just through the first half of the year, it’s been roughly about $36 billion or $37 billion. Now, to put that in perspective, that’s greater than all of last year. So within the fixed income market, there’s been a lot of capital flow happening.
But what we’re seeing right now is just that interest rates across the globe are incredibly low. So if you’re a U.S.-based investor, especially a U.S.-based investor that has a high tax bracket, the after-tax relative value that you can be getting from municipals is quite high. So you have good relative value, and, at the same time, the overall credit market’s relatively healthy.
So there’s always going to be a credit event here and there. Puerto Rico’s been getting a lot of press recently, but we’re very constructive on the overall credit health.
Akweli Parker: Okay, so let’s talk a little bit more about the credit market. Could you take a moment to go a little bit deeper in that? So you mentioned Puerto Rico. Detroit also comes to mind. Can you talk about Vanguard’s view of these and similar events, and what do they mean for the big picture?
Edward Saracino: Yeah, so it’s a very large market, Akweli. It’s roughly about $3.7 trillion, with about 80,000 issuers. So, at any point in time, there’s always going to be an issuer or two that’s under stress. Now, the one thing with the municipal market that’s worth noting is that, these credit events, they don’t happen overnight.
You know, Detroit’s an example that you gave. There was a lot of changes in their economy that’s been taking place over the last 20 or 30 years. So this is something that evolves in time.
Now, of the 40 people that I partner with that I mentioned earlier, 20 are dedicated exclusively to helping us determine the underlying creditworthiness of these underlying issuers. And we recognize that there’s asymmetric risk here. And what I mean is that the risk to the downside, at times, for a lot of these issuers is greater than the upside capture that you can get.
In trying to be able to provide predictable, consistent, high-quality performance for our clients, we tend to be discerning with how we allocate capital. And if we do believe that the risk to the downside is significantly greater, we typically just avoid those issuers altogether.
Akweli Parker: Now, on a related point, Ed, a common thread of inquiry we get from clients is around liquidity. Can you talk about that a little bit?
Edward Saracino: Yeah, definitely. So if you think about the municipal bond market, you know, it’s still a very traditional market. And what I mean there is it’s negotiated. So you’re going to have somebody working on Vanguard’s bond desk working with a dealer negotiating a price.
That takes a little bit longer. It’s going to be a little bit different than what you see in equity markets. But I will say that liquidity has been fairly consistent ever since the end of the financial crisis.
So liquidity comes up a lot. You’ve been noticing changes in liquidity ever since the financial crisis as the broker-dealer community are just keeping less bonds made available on their balance sheet, which, in turn, would impact the overall liquidity of the marketplace itself.
So we recognize this. We’re very mindful of this. So the way that it would impact our clients is twofold. One is going to be when money’s coming into the portfolio.
Now, when we implement cash flows, as I mentioned earlier, from a philosophical standpoint, we offer style-pure portfolios. They’re active funds where we’re trying to deliver alpha to our clients; but we have very diversified sources of alpha, so that allows us to be able to implement cash flows very efficiently.
Now, the other end of that would be what happens if clients need to redeem money. So we’re mindful of that too, and we’ve built in structured liquidity within our portfolio. And I think about it as insurance. And, essentially, what I mean there is, if you live on a floodplain, you’re going to buy flood insurance. We’re offering pooled mutual funds to hundreds of thousands of clients made available. There is the potential that people might want to redeem their assets. So within those liquid securities, that structural liquidity that we’ve put in place, it allows us to potentially implement outflows if we need to without compromising the rest of the portfolio.
Now, I think you know, Akweli, and you recognize that insurance isn’t free. So there is going to be a certain cost associated with that. And, typically, liquid securities offer a little bit less yield. But I think the point earlier, just our operating structure allowing us to run this at 12 basis points, we can have very ample liquidity in our portfolio and still provide very competitive performance.
Akweli Parker: Got it. So this has been a really fascinating look at the municipal bonds portion of the fixed income landscape. Are there any other points that you’d like to make?
Edward Saracino: No, I think we covered some good ground today, Akweli. I think, you know, the key point is, in what we’re just trying to offer the marketplace is that, from a pure philosophical standpoint, we recognize that clients are utilizing our funds as a way to provide diversification in their broader portfolio.
And, there’s always ways to be able to implement risk, so be it, if you need within your broader portfolio. But from conversations with our clients, they tend to want their municipal bond fund to be a very safe, risk-controlled portfolio, and that’s what we’re trying to offer.
Akweli Parker: Ed, thanks for your insights today. We appreciate you stopping by.
Edward Saracino: Thank you.
Akweli Parker: And thank you for joining us for this Vanguard Investment Commentary Podcast. To learn more about Vanguard’s views on municipal bond funds or fixed income markets in general, visit our website; and be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening!
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