Your CDs Feel Safe. The 1.5 Percentage Points of Income They’re Not Paying You Aren’t.

I have never really been a fan of certificates of deposit (CDs). Yes, the principal is guaranteed and insured by the Federal Deposit Insurance Corporation (FDIC), but the lockup period is extremely inflexible. If I need emergency cash or dry powder to buy the dip, I do not want my money trapped behind an early withdrawal penalty. 

They are often pitched as a safe place to park cash, but once you start building CD ladders to get around the liquidity problem, I start asking why not simply use Treasury bills instead. Treasury bill ladders accomplish much of the same thing while generally remaining more flexible and easier to trade.

The other issue is taxes. Interest earned from CDs is treated as ordinary income and taxed at your full marginal federal and state income tax rates. Depending on your tax bracket, what you actually keep after taxes can end up being meaningfully lower than the headline rate advertised by your bank.

I think if your goal is keeping money relatively safe and liquid while still earning tax-efficient income, there is a case for short-term municipal bonds instead over CDs. And rather than trying to pick individual bonds yourself, I would rather simply outsource the process to an ETF.

Keeping Money Safer While Earning Yield

If your goal is capital preservation with some income potential while still maintaining liquidity, one ETF worth considering is the iShares Short-Term National Muni Bond ETF (NYSEARCA: SUB). This ETF tracks a benchmark of 2,843 municipal bonds with an average duration of just 1.82 years. Duration measures sensitivity to interest rates, and at under two years, SUB is fairly resistant to rate volatility compared to longer-term bond funds.

Now, to be clear, it is not as safe as an FDIC-insured CD or a money market fund maintaining a stable $1 net asset value. Bond ETFs still fluctuate modestly in price. But the underlying credit quality here is extremely strong. Roughly 53% of the portfolio is rated AA, with another 28% in AAA-rated municipal bonds. The remainder is spread across A-rated bonds, BBB-rated bonds, and cash holdings. And despite what investors sometimes think, AA-rated municipal debt is already considered extremely high quality from a credit perspective.

As a national municipal bond ETF, SUB owns bonds issued by all across the country, though California, Texas, and New York currently make up the largest state exposures followed by Illinois and New Jersey. The ETF is also fairly inexpensive with a 0.07% expense ratio. Liquidity is solid too, with a very tight 0.01% 30-day median bid-ask spread that allows investors to move in and out efficiently, especially if you’re transacting large amounts.

How Much Income Does SUB Pay?

This is where many investors misunderstand municipal bond ETFs. At first glance, SUB’s 2.62% 30-day SEC yield may seem unimpressive relative to a CD or Treasury bill. But the key detail is that SUB’s headline yield is already exempt from federal income taxes.

That means the correct comparison is not against taxable yields directly. Instead, you want to look at the tax-equivalent yield, which estimates what a taxable investment like a CD would need to yield in order to match the tax-free income generated by SUB.

For national municipal bond ETFs like SUB, this calculation assumes the highest federal income tax bracket. According to iShares data as of May 19th, SUB’s tax-equivalent SEC yield works out to 4.42%. And suddenly, the comparison against CDs starts looking a lot more competitive.