Most investors evaluating bond ETFs compare yields and expense ratios and stop there. What that comparison misses is the tax treatment of the income, which in high-state-tax environments can meaningfully change which fund actually puts more money in a retiree’s pocket.
The iShares US Treasury Bond ETF (CBOE:GOVT | GOVT Price Prediction) is one of the clearest examples of a fund where the headline yield understates the real value for the right investor. The fund holds Treasury securities across a broad range of maturities, charges 0.05% per year, manages $40.6 billion in assets, yields 3.53%, and pays income monthly.
It has returned 0.29% year to date and 4.11% over the past year, but it’s not these numbers that are the reason to own this fund, it’s actually, and surprisingly, federal law.
The Tax Exemption Most Investors Overlook
Under 31 U.S.C. Section 3124, interest earned on US Treasury obligations is exempt from state and local income tax. This is not a loophole or planning strategy. Instead, it is a statutory right that applies to every investor holding Treasury securities, including through ETFs that hold Treasuries as their underlying assets.
The iShares US Treasury Bond ETF qualifies because its portfolio consists entirely of Treasury obligations. For retirees living in states with high income tax rates, this exemption translates directly into additional after-tax income. On a $500,000 position yielding 3.53%, the fund generates approximately $16,650 per year in income. In California, where the state income tax rate is 13.3%, a retiree in that bracket keeps the full $17,650 because state tax does not apply.
The state tax that would otherwise be owed on that income comes to approximately $2,347 per year, which over 20 years represents roughly $46,940 in cumulative savings on a single $500,000 position. In the New Year, at 10.9%, the annual savings on the same position run to approximately $1,924. In New Jersey, at 10.75%, it comes to approximately $1,897.
How It Compares to Corporate Bond Alternatives
The honest comparison here requires doing the after-tax rather than the pre-tax math. The Vanguard Short-Term Corporate Bond ETF (NASDAQ:VCSH) yields approximately 4.28%, on a pre-tax basis, which looks more attractive than the iShares Treasury Bond ETF’s 3.53%.
However, corporate bond interest is fully subject to state income tax. In California, the 4.28% is really roughly 3.71% after the 13.3% state tax. The iShares US Treasury Bond ETF at 3.53% retains its full yield, narrowing the gap from 75 basis points pre-tax to roughly 18 basis points after California state tax. In states with even higher effective rates, or for investors combining state and local taxes in places like New York City, the after-tax gap narrows further or disappears entirely.
The current yield spread does not fully flip in the iShares US Treasury Bond ETF’s favor at 3.53%, but for investors in the highest state tax brackets, the difference in after-tax income is far smaller than the pre-tax yields suggest, and the Treasury fund carries something the corporate bond fund does not with zero credit risk.
What Zero Credit Risk Actually Means
US Treasury Obligations are backed by the full faith and credit of the federal government. There is no credit analysis required, no issuer default to underwrite, and no spread widening to worry about during periods of credit market stress.
In March 2020, investment-grade corporate bond ETFs sold sharply as credit spreads blew out. Treasury funds held far steadier, and for a retiree who needs the income to arrive reliably every month regardless of what credit markets are doing, that difference in behavior during stress periods is not abstract. Monthly distributions from the iShares US Treasury Bond ETF are not contingent on corporate earnings, debt covenants, or refinancing conditions.
Who This Fund Makes Sense For
The iShares US Treasury Bond ETF is not the right choice for every fixed-income investor. Retirees in states with no income tax, such as Florida or Texas, capture no state tax benefit and would likely find the higher gross yield of a corporate bond fund more attractive.
However, for investors in states like California, New York, and New Jersey, as well as other high-tax states, who are building a monthly income stream from taxable accounts, the after-tax yield comparison deserves to be part of the decision. At 0.05% in annual fees and with Treasury-level credit quality, the iShares US Treasury Bond ETF earns its place in a thoughtfully constructed income portfolio.