The iShares 3-7 Year Treasury Bond exchange-traded fund (ETF) (NYSEARCA: IEI) attempts to reproduce the investment returns and yield, before fees and expenses, of the Barclays U.S. 3-7 Year Treasury Bond Index, or the underlying index. The fund's underlying index is composed of U.S. Treasury bonds with remaining maturities between three and seven years; the issue date of the bonds does not matter.

Treasury bonds are considered the safest security investments on the market, at least as far as protection of principal is concerned. Every issued Treasury bond is backed by the full faith and credit of the U.S. government. The Federal Reserve can pump unlimited amounts of money to bail out the Treasury, meaning every government bondholder is virtually guaranteed a nominal return of principal upon maturity.

This ETF specifically focuses on bonds between three years and seven years until maturity. Such a strategy has two effects. First, it ignores a large number of short-term maturing Treasurys; most of the federal debt is issued on short-term debts. Short-term or readily maturing bonds tend to have higher prices and lower yields; thus, IEI artificially boosts yields in a way broad Treasury funds do not.

The second effect of limiting exposure to just three to seven year maturities is to concentrate the impact of interest rate movements. Interest rates affect the prices of all Treasurys, but the impact is more or less significant as you travel across the yield curve. IEI ignores short- and long-term maturities, which means its investments tend to synchronize more uniformly with rate fluctuations.

How It Tracks It

Under normal circumstances, the fund invests at least 90% of available assets in the same bonds that comprise the underlying index. These bonds are all U.S. government bonds with a maturity between three and seven years out.

As of mid-2015, IEI had the greatest exposure to U.S. Treasury notes with stated coupons of 2.25% and 1.5%. In fact, every single bond in the top 10 holdings carried a rate between 1 and 3.5%, the kind of narrow spread to be expected from a narrow range of maturities. Portfolio wide, 62% of all coupons in IEI fall between 1 and 2%. Twenty-five percent of coupons fall between 2 and 3%. All other bonds are less than 1% or between 3 and 4%.

Only 1% of all included bonds have a maturity of three years. The majority, at 56%, fall between 37 months and five years. The remaining 43% of bonds mature somewhere between five years and seven years into the future. A very small percentage of less than 1% of the portfolio is reserved for cash positions or other derivatives.

Overall, IEI tracks the underlying index very efficiently. In fact, the fund often lags the index by less than its fees. This shows excellent management and an ability to avoid unnecessary capital gains.

Management

IEI is a BlackRock release and part of the wildly successful iShares fund series. iShares is the world's largest ETF provider with more than 500 funds and accounts for more than 40% of the entire U.S. ETF market. The iShares 3-7 Year Treasury Bond ETF has been around since January 2007. It is structured as an open-ended fund under the Investment Company Act of 1940.

Characteristics

As of mid-2015, IEI had accumulated approximately $5.5 billion in total assets, making it the third-largest government-bond focused ETF on the market. Volume is quite strong; IEI shares trade an average of 385,000 times per day with a volume in excess of $40 million; median volume is closer to 200,000 and $25 million.

The expense ratio for IEI is 15 basis points, or 0.15%, which is about standard for most funds in the segment. This rate is also 75% lower than the average ratio for a generic ETF. Overall efficiency for IEI is great, especially when compared with competitor funds.

Suitability and Recommendations

This is a good ETF for investors looking for exposure to intermediate-term U.S. Treasury bonds. IEI carries a massive and stable asset base and is highly liquid, so investors can rest assured closure is nowhere on the horizon. Bond ETFs, such as bonds, tend to not be as liquid as equity-focused ETFs. IEI is a pleasant surprise in that regard.

IEI carries a unique blend of risks. Though the fund is an equity security and acts like a stock, the underlying portfolio is full of debt obligations, which carry counterparty risk. However, the counterparty risk for Treasurys is different; the U.S. government is not likely to explicitly default on loan obligations. However, it might implicitly default through the printing press, and inflation can eat away principal after it is paid back. Thus, IEI carries equity risk and added inflation risk thanks to the nature of its portfolio.

The risk measurements for IEI paint it as a well-run but not overwhelming ETF. It has a surprising 36-month beta of 1.40 against the best-fit index, which is more volatile than many bond investors like to see. The alpha is negative, but not significantly so, and the R-squared is extremely tight. What does stand out is a standard deviation below 3, which is extremely consistent for an ETF.

How a Financial Adviser Client Can Use This ETF

This is an excellent choice for investors who want exposure to the intermediate bond market. IEI is a very large fund and is highly liquid, so it can also be used for more aggressive traders thanks to its considerable volume.

Bond funds are solid choices as hedges or as a core for older investors. IEI serves nicely in this role because it ignores the lowest-yield bonds while simultaneously leaving out the bonds with the greatest risk.

This EFT probably will not form the core position for any long-term portfolio. The underlying portfolio is bond-focused, so returns tend to lag over time compared to stock-focused funds. Instead, IEI is a more tactical holding with unique advantages for the right client.

Main Competitors and Alternatives

No other ETFs or exchange-traded notes (ETNs) track the Barclays Capital U.S. 3-7 Year Treasury Bond Index, which gives IEI somewhat of a unique place in the market. Though there are many other Treasury bond ETFs, only one other fund targets the same segment of bonds: the 3-7 Year U.S. Treasury Index Fund, which is a PIMCO release. However, IEI is more than 600 times the size of PIMCO's challenger.

A more serious challenger to IEI actually comes from in house. BlackRock also offers the iShares U.S. Treasury Bond ETF, a $1.3 billion fund focused on bonds of all maturities. This is a decent alternative for any investor looking for a more broad exposure to the government bond market.

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