Short-Term Treasury Exposure at a Modest Fee

This fund only invests in Treasury bonds. So, its performance can diverge from the short-government category average because its typical peer equally divides its assets between Treasuries and agency mortgage-backed-securities. Unlike Treasuries, these mortgage-backed securities do not enjoy the full backing of the U.S. government. But the market tends to price them under the assumption that the U.S. government will back them if necessary (even though there is no contractual obligation for the government to do so). And they are generally backed by high-quality debt. Hence, most funds in the category have a similar, low-credit-risk profile. Also, this fund's duration of two years as of January 2017 was similar to its peers, introducing moderate interest-rate risk. With average credit and duration risk, this fund's yield is on par with the category average.

This fund has successfully tracked its index since its switch from the Bloomberg Barclays U.S. 1-3 Year Treasury Bond Index to the ICE U.S. Treasury 1-3 Year Bond Index in April 2016. From April 2016 to January 2017, the fund lagged the benchmark by 0.11%. This gap is less than its 0.15% fee, but its track record against this bogy is still short.

The fund provides robust downside protection because Treasury securities tend to act as a safe-haven asset. For example, during the 2013 taper tantrum and 2007 financial crisis, the fund's performance ranked in the category's top 10%. Its annualized return of 1.9% over the 10 years ended January 2017 trailed the category average of 2.4%. But its risk-adjusted return was better than the category average over the same period.

Fundamental View

The U.S. Department of the Treasury issues Treasury securities to fund federal government operations. These bonds have virtually no default

since the government can raise taxes to finance them. Accordingly, Treasury securities offer a very low yield. As of Feb. 14, 2017, a two-year Treasury bond yielded 1.2%, 140 basis points lower than the 20-year average (1997 to 2016) of 2.6%. Interest income on Treasury securities is tax-exempt at state and local levels, slightly improving the aftertax yield.

To improve returns, the fund's typical peer allocates roughly half of its capital to agency mortgage-backed securities. Unlike Treasury bonds, these securities are not explicitly guaranteed by the U.S. government. Hence, they offer slightly higher coupons to compensate for default risk. But they are still highly rated and trade under the assumption that the government will step up to back them if necessary. The fund takes comparable interest-rate risk to the category norm.

The fund's current yield of 1.0% is similar to those of its peers. But, its annual returns over the trailing three- and five-year periods through January 2017 of 0.53% and 0.43%, respectively, were both behind the category average. This was primarily due to the fund's exclusion of agency debt.

However, this fund offers good downside protection and has outperformed its peers during market downturns. When markets go through a period of stress, Treasuries attract a lot of investor demand because of their perceived safety. During the taper tantrum of 2013, the fund gained 0.23% while the category average was down by 0.89%. In 2007, its 7.3% return beat 90% of its category peers. The fund's worst downturn over the trailing five years through January 2017 was among the most mild in the category, ranking in the top 10%. Furthermore, the fund's 10-year Sharpe ratio, a measure of risk-adjusted return, outpaced 60% of its peers through January 2017. Given the fund's cost advantage and low-risk holdings, it should continue to generate attractive category-relative risk-adjusted returns over the long term.

Portfolio Construction The fund earns a Positive Process rating because it accurately captures the short-term Treasury market and weights its holdings by market capitalization. This weighting approach tilts the portfolio toward the most-liquid issues, which helps promote low transaction costs.

The fund uses a sampling strategy to track the ICE U.S. Treasury 1-3 Year Bond Index, which measures the performance of U.S. Treasury bonds with between one and three years until maturity. As of Dec. 31, 2015, there were 90 issues in the index. The index includes publicly issued U.S. Treasury securities that have $300 million or more of outstanding face value, excluding amounts held by the Federal Reserve. In addition, the securities in the index must be fixed-rate and denominated in U.S. dollars. Excluded from the index are inflation-linked securities, Treasury bills, cash management bills, any government agency debt, and zero-coupon issues that have been stripped from coupon-paying bonds. The index is weighted by market capitalization, and the constituents are updated on the last business day of each month.

Prior to April 1, 2016, the fund tracked the Bloomberg Barclays U.S. 1-3 Year Treasury Bond Index. There were no meaningful changes in the performance and characteristics of the fund after the change. BlackRock made the change to diversify its services providers and benefit from ICE's operational expertise in providing fixed-income pricing.

Fees The fund has an expense ratio of 0.15%, which is among the lowest in the short-government category, supporting the Positive Price Pillar rating. This fund is cheaper than 88% of its category peers and is much lower than the 0.72% category average. Thanks to this cost advantage and effective management, this fund has tightly tracked its underlying index. The fund underperformed the benchmark by 11 basis points since it changed the index in April 2016. It also successfully tracked its prior index.

Alternatives Schwab Short-Term U.S. Treasury ETF SCHO tracks the Bloomberg Barclays U.S. 1-3 Year Treasury Bond Index and provides nearly identical exposure to SHY at a lower cost of 0.06%. This market-cap-weighted fund targets Treasury securities with between one and three years until maturity. Qualifying bonds only need to have $250 million in face value, which is lower than SHY's requirement by $50 million. This difference can potentially increase transaction costs when the fund rebalances. However, the net impact for investors is likely to be minimal.

Vanguard Short-Term Government Bond Index Fund ETF VGSH (expense ratio 0.05%) is also a strong, low-cost option. It replicates the Bloomberg Barclays U.S. 1-3 Year Government Float Adjusted Index and dips into agency mortgage-backed securities, eking out a slightly higher yield than SHY with a comparable duration.

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