Tax-Exempt Fixed Income Opportunities in a Rising Rate Environment: Evaluating VTEB for Income-Seeking Investors

In 2025, the U.S. bond market faces a complex landscape shaped by rising interest rates, fiscal uncertainty, and shifting investor priorities. For income-seeking investors, tax-exempt municipal bonds remain a compelling asset class, particularly for those in higher tax brackets. The Vanguard Tax-Exempt Bond ETF (VTEB), a broad-based index fund tracking the municipal bond market, offers a unique blend of yield, diversification, and cost efficiency. However, its attractiveness in a rising rate environment hinges on a nuanced understanding of its risk-return profile and the broader market dynamics.

The Case for Tax-Exempt Municipal Bonds in 2025

Tax-exempt municipal bonds have maintained elevated yields in 2025, with the Bloomberg Municipal Bond Index reporting a yield-to-worst of 3.96% by mid-year—a level higher than 95% of historical observations over the past decade [5]. This performance is underpinned by strong credit fundamentals, with 72% of municipal bonds rated AAA/Aaa or AA/Aa, and default rates remaining historically low [5]. For taxable investors, the tax-equivalent yield of high-quality long-term munis is particularly compelling. A 4.80% yield on a municipal bond, for instance, translates to an effective 7.62% return for someone in the 37% federal tax bracket [2]. This makes munis a strategic alternative to equities and Treasuries, especially as the yield curve steepens, offering a 1.5% spread between 10-year and 30-year maturities—the steepest since 2013 [1].

VTEB’s Position in the Market

VTEB, with a 30-day SEC yield of 3.78% and a dividend yield of 3.29%, aligns with the broader municipal bond market’s performance [1]. Its low expense ratio of 0.03% further enhances its appeal for long-term investors [1]. However, the fund’s effective duration of 7.30 years exposes it to significant price volatility in a rising rate environment [4]. Duration measures a bond’s sensitivity to interest rate changes, and longer durations amplify losses when rates rise. For example, a 100-basis-point increase in rates could reduce VTEB’s net asset value by approximately 7.3%, a risk that must be weighed against its income potential.

Balancing Yield and Duration Risk

The decision to allocate to VTEB depends on an investor’s risk tolerance and tax situation. While its long-duration profile offers higher yields, it also introduces greater interest rate risk. In contrast, shorter-duration alternatives like the Vanguard Short-Term Tax-Exempt Bond ETF (VTES), with a duration of 2.5 years, provide more stability but lower yields [4]. For investors prioritizing capital preservation, VTES may be preferable. However, those seeking to capitalize on the steep yield curve and tax advantages of munis might find VTEB’s intermediate-to-long-term exposure more rewarding, particularly if they can hold the fund through rate-driven volatility.

Market Challenges and Opportunities

The municipal bond market faces headwinds in 2025, including a surge in new-issue supply driven by infrastructure spending and inflationary pressures. Record issuance of $256 billion in the first half of 2025 has increased supply, potentially pressuring yields [5]. Additionally, concerns about Medicaid cuts and state tax policies could impact issuer flexibility [3]. Despite these risks, the tax-exempt status of munis and their strong credit quality continue to attract demand, especially as equities face volatility from trade tensions and stagflation fears [3].

Conclusion

VTEB’s role in a rising rate environment is best understood through a dual lens: its ability to generate tax-advantaged income and its vulnerability to rate-driven price declines. For high-tax-bracket investors with a medium-term horizon, the fund’s yield and diversification benefits may outweigh its duration risk. However, those prioritizing stability should consider shorter-duration alternatives. As the municipal yield curve remains steep and tax-equivalent returns remain attractive, VTEB offers a strategic option for income seekers willing to navigate the complexities of a dynamic bond market.

Source:
[1] Opportunities in today's municipal market [https://advisors.vanguard.com/insights/article/opportunities-in-todays-municipal-market]
[2] Here's Why Munis Aren't Just for Wealthy Investors Now [https://www.kiplinger.com/investing/bonds/why-munis-arent-just-for-wealthy-investors-now]
[3] Municipal Bonds: Mid-Year 2025 Outlook [https://www.schwab.com/learn/story/municipal-bond-outlook]
[4] Vanguard Tax-Exempt Bond ETF VTEB Portfolio [https://www.morningstar.com/etfs/arcx/vteb/portfolio]
[5] Top 5 Muni Market Insights 2025: Mid-Year Update [https://www.newyorklifeinvestments.com/insights/2025-municipal-market-insights-midyear]