Form N-CSRS SIT MUTUAL FUNDS II INC For: Sep 30

Semi-Annual Report

September 30, 2020

U.S. Government Securities Fund

Quality Income Fund

Tax-Free Income Fund

Minnesota Tax-Free Income Fund

Important Information on Paperless Delivery

Beginning on January 1, 2021, as permitted by regulations adopted by the Securities and Exchange Commission, paper copies of the Funds’ shareholder reports will no longer be sent by mail, unless you specifically request paper copies of the reports from Sit Mutual Funds or from your financial intermediary, such as a broker-dealer or bank. Instead, the reports will remain available on the Funds’ website (sitfunds.com) and you will be notified by mail each time a report is posted and provided with a website link to access the report.

If you already elected to receive shareholder reports electronically, you will not be affected by this change and you need not take any action. You may elect to receive shareholder reports electronically from the Fund by calling 1-800-332-5580 or by enrolling online at sitfunds.com, or, if you are invested through your financial intermediary, you may contact them directly.

You may elect to receive all future reports in paper free of charge. You can inform the Funds by calling 1-800-332-5580, or, if you are invested through your financial intermediary, you may contact them directly. Your election to receive reports in paper will apply to all funds held with Sit Mutual Funds or through your financial intermediary, as applicable.

Dear fellow shareholders:

According to Chinese tradition, it is reputed to be a curse to wish upon an adversary: “May you live in interesting times”. If such an imprecation exists, we surely fell under its spell this year. Of course, “interesting” does not do justice to 2020. Indeed, it was Lenin who ominously said: “There are decades where nothing happens; and there are weeks when decades happen.” The six-month period ended September 30, 2020 contained such weeks. The world experienced the worst pandemic in a century and the most severe and abrupt collapse in economic activity since the Great Depression. Extraordinary volatility enveloped the financial markets. These six months will long be remembered, analyzed and debated by historians for the decisions made, their consequences, and the long-lasting changes in the ways we live, work, and interact as a society.

These six months were also characterized by the initial steps to re-open the U.S. and global economies. This period is marked not only by a freefall of the economy but also by a remarkably powerful rebound of much of it and the resilience of financial markets. However, perhaps no aspect of this period is more significant and long-lasting than the monetary and fiscal “shock and awe” campaign unleashed by the Federal Reserve and the federal government to force the economy and markets out of crisis. We will recover from this economic plunge in coming months, but the after-effects of the massive government interventions will persist, shaping market environments far into the future.

The New Era of Whatever it Takes

During the last six months, the Federal Reserve and Congress demonstrated an extraordinary commitment to doing whatever is necessary to ensure liquidity and stability in financial markets. The Fed had already slashed the Fed Funds rate in two cuts by March back to the all-time low of 0.00%-0.25% last seen in the throes of the Great Recession in 2008 (and not raised until late 2015). That was just the opening salvo this time. With monetary policy constrained by an almost zero fed funds rate, the Federal Reserve unleashed an array of actions which meaningfully exceeded the level of response to the 2008 liquidity crisis. The Fed quickly began massive buying of mainly Treasuries and Agency mortgage-backed securities that totaled almost $3 trillion. These purchases equaled a large portion of the annual volume of those markets. Fed holdings are expected to exceed $9 trillion by year end. The combined sum of the Fed and European Central Bank balance sheets ($14.7 trillion by 9/25/20) surged +65% year-over-year. Unwinding these positions in an orderly manner is likely to take decades and ensure that government intervention persists well beyond the pandemic.

Beyond the massive bond purchases, the Fed also established 11 major emergency aid programs to maintain smooth functioning of a wide variety of markets. Most of these programs were new and brought the reach of the Fed further than ever before. These included programs to aid primary Treasury bond dealers, the corporate commercial paper market, money market mutual funds, the asset-backed securities market (which finances credit cards and autos, for example), and one for lending to state and local governments. The Fed also

instituted massive direct lending to small and medium size businesses. Furthermore, it created programs to directly buy investment grade corporate bonds in the bond market – a new first for the Federal Reserve. The Fed intervention has been so large that it elevated the Fed’s credibility to the point where the Fed didn’t have to utilize all the available funding for these programs. The confidence the Fed instilled in the markets and the economy by these sweeping measures turned the tide.

The Fed pushed further into unknown territory in late August as it announced a fundamental shift in policy to “inflation averaging.” Essentially, this means it will let inflation run above its longstanding 2% target. Additionally, the Fed shifted its stance to de-emphasize the traditional monitoring of the unemployment rate to gauge if the economy will overheat and inflation pick up. Employment levels can now run at or above full employment estimates without causing concerns over a pre-emptive Fed reaction to raise interest rates. The Fed has also announced enhanced guidance that states its intention to keep short rates near zero until at least 2023.

Congress did not stand idle; it moved fast to provide economic relief totaling $4 trillion since March, with approximately 60% disbursed or committed by September 30. Combined with Federal Reserve and executive actions, total stimulus aid now exceeds $11 trillion, or about 60% of annual GDP, bringing federal outlays to levels not seen since WWII. The corresponding spike in U.S. Treasury issuance has been offset by Fed purchases. This means that the Fed, by buying up so much Treasury debt, was financing the widening surge in the budget deficit arising from the federal spending binge. This exercise in Modern Monetary Theory may have an undesirable impact on inflation and the U.S. dollar eventually.

For the Economy, the Worst and the Best of Times

The Fed’s massive intervention was highly effective. The recession of the first half of 2020 was the deepest as well as the shortest in modern history. This is not surprising, since it was triggered by a manufactured lockdown. The U.S. economy shrank by an annualized -31.4% quarter-to-quarter rate in the 2Q of 2020. That left GDP $2 trillion below the peak in the 4Q of 2019. (A 5% decline occurred in 1Q 2020.) A huge bounce in 3Q 2020 GDP is shaping up to be over +25%. The massive stimulus and controlled re-openings explain why the U.S. economy experienced close to a V-shaped recovery. A large jump in manufacturing orders and the ISM Manufacturing Purchasing Managers Index led to improved business confidence and an improved capital expenditures outlook. Housing starts rose 22.6% in July, the most since October 2016; building applications rose 18.8% during July, the highest increase since January 1990.

However, even the optimistic estimate for 3Q20 GDP would still leave it short of the peak in 4Q 19 by over $600 billion. GDP may not return to its prior top until 2022, driven by pent-up demand, inventory replenishment, and monetary stimulus. U.S. economic normalization is lagging because fiscal disbursements peaked; a fiscal cliff has arisen. Consumer spending, which accounts for just under 70% of GDP, had a strong snapback but may fade as consumers tap more

into savings. Initial unemployment claims remain elevated, even relative to 2009; job postings ebbed in August. The post-lockdown economic recovery remains highly vulnerable to coronavirus shocks. The first quarter of 2021 will be a major inflection point in financial markets as vaccines begin to be distributed in various places around the world. Investors will focus on how quickly vaccines are distributed through mid-2021 to predict the strength of the economic rebound. We believe investors will underestimate the timing and degree of the vaccine-fueled economic rebound. The U.S. may probably be one of the last countries to formally approve a vaccine. In the near term, this may provide significant investment opportunities before a solid rebound in 2021.

The Bond Markets Respond Exceedingly Well to the Medicine

As the Fed bought up Treasuries and MBS, as well as sectors they had never purchased before (investment grade corporate bonds and high-yield ETFs), it sparked an explosive rally in early spring. By summer, a regime of tightly controlled ultra-low rates and low volatility emerged. The 10-year Treasury bond yield had begun the year at 1.92% and fallen as low as 0.54% on March 9. In contrast, during the six months ended 9/30/20, it began at 0.70% and ended at 0.69%. Intra-period, it ticked up briefly as high as 0.91% on 6/5/20 and just barely set a new low of 0.52% on 8/4/20. October started with the 10-year Treasury bond yield breaking out of this range. The real bond yield (net of inflation) likely reached a low of -1.12% on 9/2/20 and is now trending up to the 200-day moving average of -0.50%, 40 percentage points higher than the current level. Steepening trend of the yield curve also developed as the period ended with a difference of 1.33% between the 30-year and 2-year Treasury bond yields, approximately 0.50% higher than when the year began.

The Fed’s intervention allowed investors to overcome tragic economic data, low corporate earnings, and the impending wave of rating downgrades and high yield defaults. Notably, investment-grade corporate yields hit an all-time low of 1.82% in early August as spreads set a new post-coronavirus low of just 1.24% above Treasury bond yields. However, not all spreads have recovered. Securities with lower credit ratings still have room for further price improvement. The Fed actions also sparked a record amount of debt issuance. Treasuries, MBS and investment grade corporate bonds are all on course to see record issuance volumes in 2020. Over $1.2 trillion corporate bonds were issued in the first half, matching the previous full year record set in 2017.

Municipal market momentum also stalled in mid-August and September after a historic comeback in the prior three months. The market movement of early summer fully offset the historic and sudden dislocation of early Spring for all but lowest quality credits. The AAA municipal bond yield curve from 10 to 30 years ended September just 29 to 35 percentage points above all-time lows set in early August. After sluggish issuance in March and April, YTD municipal issuance now totals the highest on record for the first nine months of any year. Taxable municipal bonds were responsible for this surge and lead all major fixed income sectors in YTD returns on 9/30/20.

Our Strategy

The near-term outlook is clouded by the upcoming elections. The 2016 election is a reminder to place post-election market moves in context. That may be especially relevant this year given the potential for a delayed result. Additional stimulus talks remain fluid. Even more fiscal support will only enhance the recovery’s prospects. The Democratic agenda entails approximately $7.2 trillion in new spending over ten years, offset by $3.9 trillion from higher taxes and other revenue. The added growth would likely come at the expense of a higher federal debt burden and uncertain tax effects.

Uncertainty will dissipate after the election season and set the stage for higher risky asset prices and bond yields. The Sit Quality Income Fund is investing in bonds benefitting from the Fed’s bond purchase programs. Such securities include investment grade corporate bonds, money market securities, agency mortgage bonds, asset-backed bonds, and more. Furthermore, we are looking to take advantage of any near-term weakness in bonds as our longer-term view is for improved economic activity in 2021. The Fund will also be positioned defensively against a potentially higher than expected increase in inflation. Within the Sit U.S. Government Securities Fund we continue to position the Fund defensively against global concerns of the COVID-19 virus while maintaining the Fund’s focus on seasoned, high coupon agency mortgage securities which provide a high level of income with relatively stable prices.

We suggest that this is an attractive time to add to municipal portfolios. Municipal bonds are relatively cheap among fixed income sectors. On September 30, the 10-year municipal bond yield closed at 128% of the 10-year Treasury yield vs. an average of 86.2% since 1985. Furthermore, the potential for hikes in income tax rates as well as another stimulus package providing major budgetary relief for states offers a highly appealing dynamic for tax exempt bonds heading into 2021.

We remain optimistic about the long-term prospects for the U.S. economy but acknowledge that challenging times are faced in the near to intermediate term. Despite the extraordinary measures taken, credit rating downgrades have begun, and more are coming. We believe that active investment management can excel in this environment. Our income orientation and positioning in defensive sectors should differentiate our performance. The nation and the markets have experienced unprecedented shocks over the last six months. There have been tragic and painful experiences that we hope and expect our nation will draw wisdom from and eventually move past.

We appreciate your continued interest in the Sit family of funds.

With best wishes,

Roger J. Sit

Chairman and President Sit Mutual Funds

Fund Performance

The Sit U.S. Government Securities Fund (Class S) provided a return of +0.66% during the 6-month period ending September 30, 2020, compared to the return of the Bloomberg Barclays Intermediate Government Bond Index of +0.75%. The Fund’s 30-day SEC yield was 2.04% and its 12-month distribution rate was 1.68%.

Factors that Influenced the Fund’s Performance

During the 6-month period, the Fund benefited from the consistent relatively high level of income provided by its holdings in higher coupon government agency mortgages. U.S. Treasury securities steepened with longer maturities increasing in yield and shorter maturity securities decreasing in yield. The Fund typically performs well as shorter maturities decrease in yield, however, due to market expectations of future elevated prepayment speeds, prices on mortgage securities underperformed relative to the benchmark. Despite declining mortgage rates, the Fund continues to experience relatively stable prepayment rates as the mortgage holdings are generally well seasoned and have been through many refinancing cycles. The Fund reduces interest rate risk by using futures and options on Treasury securities. The use of futures and options was effective in providing stability to the Fund’s net asset value, however, detracted from the return.

Outlook and Positioning

The U.S. economy began to recover from one of the worst economic downturns since the Great Depression. Consumers spent at a heathy clip as government stimulus payments and vaccine developments contributed to overall consumer confidence. The Federal Reserve continued to buoy the market by keeping the Fed Funds rate below 0.25% and its ongoing asset purchase program. The Federal Reserve continues to buy investment grade corporate bonds, money market securities, agency mortgage bonds, asset-backed bonds, and more. Despite the support from the Federal Reserve, financial markets are likely to experience elevated levels of volatility in the near term as we await results of vaccine testing, the election, and sustainable improvement in the economy. As a result, we expect increased trading opportunities in the near term. Longer term, we expect yield spreads to continue to narrow as the Federal Reserve continues its purchase program and positive developments in a vaccine for COVID-19 occur. Fannie Mae and Freddie Mac announced a joint policy adjustment

HYPOTHETICAL GROWTH OF $10,000

The chart above illustrates the total value of a hypothetical $10,000 investment in the Fund over the past 10 years (or for the life of the Fund if shorter) as compared to the performance of the Bloomberg Barclays Intermediate Government Bond Index. Past performance does not guarantee future results. Returns include the reinvestment of distributions. The chart does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or the redemption of Fund shares.

¹ The Bloomberg Barclays Intermediate Government Bond Index is a sub-index of the Bloomberg Barclays Government Bond Index covering issues with remaining maturities of between three and five years. The Bloomberg Barclays Government Bond Index is an index that measures the performance of all public U.S. government obligations with remaining maturities of one year or more. The returns include the reinvestment of income and do not include any transaction costs, management fees or other costs. It is not possible to invest directly in an index. This is the Fund’s primary index.

to extend the buyout timeline for delinquent loans from 4 months to 24 months. This will provide borrowers additional time to cure delinquencies that may have been caused by the COVID-19 virus or any hardships in the past year. As a result, mortgage yield spreads should continue to narrow as any buyouts will be delayed. The Fund’s high coupon mortgages should continue to produce an income advantage in this environment as prepayments are likely to remain stable.

We continue to position the Fund defensively against global concerns of the COVID-19 virus while maintaining the Fund’s focus on seasoned, high coupon agency mortgage securities which provide a high level of income with relatively stable prices. This high level of income and stability of principal has been a fundamental focus of the Fund since its inception.

COMPARATIVE RATES OF RETURNS

as of September 30, 2020

Performance figures are historical and do not guarantee future results. Investment returns and principal value will vary, and you may have a gain or loss when you sell shares. Current performance may be lower or higher than the performance data quoted. Contact the Fund for performance data current to the most recent month-end. Returns include changes in share price as well as reinvestment of all dividends and capital gains and all fee waivers. Without the fee waivers total return and yield figures would have been lower. Returns do not reflect the deduction of taxes that a shareholder would pay on Fund distributions or the redemption of Fund shares. Management fees and administrative expenses are included in the Fund’s performance. Returns for periods greater than one year are compounded average annual rates of return.

¹ The Bloomberg Barclays Intermediate Government Bond Index is a sub-index of the Bloomberg Barclays Government Bond Index covering issues with remaining maturities of between three and five years. The Bloomberg Barclays Government Bond Index is an index that measures the performance of all public U.S. government obligations with remaining maturities of one year or more. The returns include the reinvestment of income and do not include any transaction costs, management fees or other costs. It is not possible to invest directly in an index.

² The Lipper returns are obtained from Lipper Analytical Services, Inc., a large independent evaluator of mutual funds.

FUND DIVERSIFICATION

Based on total net assets as of September 30, 2020. Subject to change.

PORTFOLIO SUMMARY

³ Duration is a measure of estimated price sensitivity relative to changes in interest rates. Portfolios with longer durations are typically more sensitive to changes in interest rates. For example, if interest rates rise by 1%, the fair value of a security with an effective duration of 5 years would decrease by 5%, with all other factors being constant. The correlation between duration and price sensitivity is greater for securities rated investment-grade than it is for securities rated below investment-grade. Duration estimates are based on assumptions by the Adviser and are subject to a number of limitations. Effective duration is calculated based on historical price changes of securities held by the Fund, and therefore is a more accurate estimate of price sensitivity provided interest rates remain within their historical range.

ESTIMATED AVERAGE LIFE

The table represents the Adviser’s estimates of the dollar weighted average life of the portfolio’s securities, which differ from their stated maturities. The Fund’s average stated maturity was 15.9 years as of September 30, 2020.

Numeric footnotes not disclosed are not applicable to this Schedule of Investments.

Fund Performance

The Sit Quality Income Fund provided a return of +2.12% during the 6-month period ending September 30, 2020, compared to the return of the Bloomberg Barclays 1-3 Year Government/Credit Index of +1.41%. The Fund’s 30-day SEC yield was 1.27% and its 12-month distribution rate was 1.37%.