VRDO Municipal Bond ETF Showdown (VRD, PVI)

Eric Dutram: The present stock market volatility and economic slowdown in most parts of the globe has brought about a massive risk off environment for investors. This has kept the demand for the ‘safe haven’ U.S Treasury Bonds relatively high and it has put a stranglehold on interest rates, keeping them near historic low levels.

The benchmark 10 Year Treasury bonds currently yield 1.71%, whereas the 20 and 30 Year Bonds sport paltry yields of 2.44% and 2.82% respectively. The minutes of the recently concluded Fed meeting (July 31st to August 1st) gave a clear indication of another round of quantitative easing (QE3) if the situation demands, mainly to improve the job situation in the economy.

However, similar indications have been previously discounted by the market but anything substantial is yet to happen. Also, a lack of proactive measures by the policy makers across the Atlantic, elections in the U.S., rising commodity prices and slowdown in the emerging markets are most likely to cause the equity and commodities markets to remain volatile in the near future, thereby pushing rates further down (see 3 Multi-Asset ETFs for Juicy Yields and Stability).

Having said this, it is prudent to note that an increase in rates is inevitable at some point of time. Given this premise, it is almost certain that Treasury bond investors will have to bear with capital loss if the trend reverses. The instruments most affected by such occurrences will be the bonds sitting at the further end of the yield curve. However, their short term counterparts have a different story altogether.

The ultra-low yield policies of the Fed have caused interest rates on short term bonds to hover near zero. At a time like this, the real returns for short term bond investors would be negative if we take inflation into account. For example, investing in 1 Year Treasury bonds sporting 0.19% and the latest CPI at 1.408% for the U.S. economy would fetch real annualized returns of -1.218% (readLooking For Income? Try These High Yield Muni Bond ETFs).

Nevertheless, short term money market instruments have limited or rendered negligible capital loss/appreciation, given their ultra low yields and very short maturities. Therefore they can be considered as the ultimate competitors for cash alternative investments, and are capable of acting as capital protectors during shaky market environments.

Enter VRDO Bonds

One such segment that is often overlooked but can provide incredible amounts of safety to investors can be found in the muni bond market with VRDO securities. These bonds, which stand for Variable Rate Demand Obligation, are floating (variable) rate bonds, for which coupon interest rates are reset at regular intervals (see Floating Rate Bond ETF Investing 101). Mostly these bonds are short term in nature, giving investors a low level of duration risk while still providing some level of income.

The most distinguishing feature of this bond is that these bonds have an embedded put option in which the lender (i.e. investor) can demand the capital invested at any point of time and the borrower (i.e. issuer) has to honor his payment obligation. At the time of redemption, the lender will be subject to receipt of the principal amount plus the accrued interest till that point of time. These bonds are purchased at par due to their floating rate nature.

Investors should also note that since they are municipal securities, interest is usually shielded from federal taxation. Thus, instruments in this category can make for excellent choices for short-term investors of high net worth individuals looking to keep tax liabilities at a low level.

Thanks to their complex structure, the bonds are often overlooked in favor of their more easy to understand counterparts. Also, due to their paltry yield and short end target of the yield curve, these bonds significantly limit the upside potential. However, the flip side also holds true. At a time when volatility has increased across all asset classes, these bonds can provide a safe haven investment avenue for investors (read The Forgotten Muni Bond ETFs).


For investors seeking a basket approach to this niche segment of the market the SPDR Nuveen S&P VRDO Municipal Bond ETF (NYSEARCA:VRD) and the PowerShares VRDO Tax-Free Weekly ETF (NYSEARCA:PVI) are pretty much the only two options at this time. Below, we have highlighted some of the key points to keep in mind for those who are considering making a play on this often overlooked market slice:

VRD tracks the S&P National AMT-Free Municipal VRDO Indexwhich captures the essence of the VRDO bonds issued by state or local government agencies which are priced at par and have a minimum nominal value of above $10 million whereas, PVI tracks the Bloomberg US Municipal AMT-Free Weekly VRDO Indexwhich tracks the performance of the VRDO bond market.

PVI was launched in November 2007, prior to the launch of VRD in September 2009. In terms of holdings, PVI has coverage of 43 VRDO securities compared to VRD holding 39 securities. The yields of both these ETFs are reset every seven days.

Also, both of these products are extremely similar in terms of strategy, risks involved and target market. However, PVI clearly outperforms its counterpart VRD when it comes to market share, popularity and liquidity. PVI has an asset base of $363.33 million and an average daily volume of 132,067 shares compared to VRD which has $12.08 million in total assets and only 4,585 shares in average daily volume.

This startling difference, however, could have serious implications; especially in case of extremely low yielding securities such as these VRDO bond ETFs. Lower traded volumes and relatively small asset base could result in high bid-ask spread ratios, which could go a long way in making the investments more costly (readComprehensive Guide to Money Market ETFs).

However, in terms of returns and yields there is very little difference among the two. VRD has returned 0.55% in the last one year period as on 30th June 2012 while distributing 0.54% as yields.

On the other hand, for the same time period, PVI has returned 0.37% and distributed 0.38% as yields. PVI also charges a higher expense ratio of 0.25% compared to VRD charging 20 basis points.

The following table summarizes the differences between the two aforementioned VRDO bond ETFs:

ETF Total Assets ($) Expense Ratio 1 Year Returns (as on 30th June 2012) Yield Inception Average Daily Volume No. of Holdings
VRD 12.08 million 0.20% 0.55% 0.54% September 2009 4,585 shares 39
PVI 363.66 million 0.25% 0.37% 0.38% November 2007 132,067 shares 43

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Written By Eric Dutram From Zacks Investment Research  

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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