- Date : 07/02/2020
- Read: 8 mins
The fund makes sense for the retail investor given its diversity, liquidity, and price clarity, say experts.
On December 4, the Modi government cleared the way for the launch of India's first corporate bond ETF, called Bharat Bond ETF. To be managed by Edelweiss Mutual Fund, it is mandated to hold only AAA-rated bonds issued by specified PSUs. Its equity counterpart, Bharat 22 fund, was launched in 2017.
Ever since the announcement was made about the launch of Bharat Bond ETF, there’s been a lot of buzz. Financial planners have been hailing the Bharat Bond ETF as a low-risk, tax-efficient, and reliable fixed-income investment option for those who prefer steady returns and liquidity.
But what exactly is a bond ETF and how does it differ from a regular ETF – or a regular bond for that matter? One needs to understand these basic points before exploring further to find out why people are so excited.
What are bond ETFs?
An ETF or exchange-traded fund is a mutual fund that trades on the exchange just like a stock. They are usually passive and replicate a stock index; for instance, a Nifty 50 ETF holds the shares in it.
A bond ETF works on the same principle, but it holds only bonds. Thus, a bond ETF will track an index of bonds and tries to replicate its returns. But these too trade on an exchange, just like stocks.
For instance, Bharat ETF will track an underlying index (Nifty Bharat Bond Index) on risk replication basis, matching credit quality and average maturity of the index. The index will be constructed by an independent index provider, the National Stock Exchange (NSE).
For the average investor, bond ETFs make sense as they offer more diversity, liquidity, and price clarity than single bonds. In addition, they offer more frequent income payments (usually monthly), as well as intra-day trading.
To invest in the fund, one has to have a demat account, though mutual fund investors also have the option of investing via a fund of funds (FoF).
Like most fixed income instruments, bond ETFs are a low-risk investment, which should appeal to investors who like to play it safe. Also, given that they are liquid in nature, bond ETFs are suitable for those saving for short-term goals.
That last feature is actually one of the key reasons for launching Bharat Bond ETF. Because it is liquid, it will create an avenue for easy retail participation. So much so that retail investors will be able to invest as little as Rs 1000 in a basket of premium bonds that would be traded at the exchanges.
In the bargain, the liquidity of India’s debt markets is also expected to increase. And as Bharat Bond ETF is mandated to invest in the bonds of select state-owned companies, it is also aimed at helping these PSUs raise funds.
However, the two ETFs – CPSE ETF and Bharat-22 ETF which were launched in 2017 – have given negative returns in the current financial year (2019-2020). The net asset value of CPSE ETF has declined 14.5% since April 1 2019, while that of Bharat 22 ETF has fallen 8.5%.
The Bharat Bond ETF
There is another difference between bond ETFs and bonds, and this is where the Bharat Bond ETF is quite interesting.
Unlike individual bonds that have a fixed, unchanging maturity date when investors get their money back, bond ETFs normally maintain a ‘constant maturity’ – that is, they follow the weighted average of the maturities of all the bonds in the portfolio.
This is how constant maturity is maintained: whenever some bonds in the portfolio are set to expire or exit the preferred age range, additional bonds are bought and sold to keep the maturity constant. As this is done on a regular basis, in a way bond ETFs have ‘no maturity’.
However, the interesting aspect of Bharat Bond ETF is that it has a defined maturity, similar to a Fixed Maturity Plan, and quite unlike the normal open-ended bond ETFs.
To start with, Edelweiss will launch two variants of Bharat Bond ETF – one maturing in three years (April 2023) and the other in 10 years (April 2020). The fund will be redeemed on maturity, and investors will be given back their money.
The fund's open-ended structure also allows investors to purchase and sell units in the stock markets to benefit from gains in the value of bonds from a decline in interest rates.
If it is offloaded within three years, it will be considered a short-term asset, and short-term capital gains (STCG) will come into play as per the income slab. If sold after three years, long-term capital gains (LTCG) of 20% with indexation will become applicable.
The issue size of the three-year variant is set at Rs 3000 crore, with the option to extend it by an additional Rs 2000 crore, while that for the 10-year variant is Rs 4000 crore, with the option to extend it by Rs 6000 crore.
In other words, Edelweiss is expected to keep launching new series, with each having an index that the ETF will track.
The excitement explained
One may well wonder what exactly is making financial planners giddy with excitement over the Bharat Bond ETF. Actually, there’s a range of reasons why people are so upbeat; let’s take a look:
- Low Expense Ratio: The very first aspect of the fund that strikes one is its low cost structure; this is the fund’s USP. With an expense ratio of 0.0005%, this bond ETF has been hailed as the ‘cheapest available investment option’ in India right now, and also probably one of the cheapest mutual fund products in the world. However, experts also say that much will depend on the market’s ability to provide adequate liquidity and ensure price discovery.
- Low Risk: The fund’s portfolio comprises high-quality bonds issued by state-owned entities, and this considerably reduces the default risk. As the government said in a statement, Bharat Bond ETF will provide safety (because of the underlying state-issued bonds), liquidity (tradability on exchange), and predictable tax-efficient returns.
- Daily Disclosures: Portfolio disclosures will be made on a daily basis on an independent website. This will ensure greater transparency compared to conventional debt funds, which reveal their portfolios only once a month.
- Predictability of Returns: In a statement, the government stressed on one aspect of the fund that should appeal to small investors a great deal: the ETF’s fixed maturity feature ensures predictability of returns. Those investing in ETF 2023 can expect 6.69% annual returns (if held till maturity), while ETF 2030 can fetch 7.58% annually. (These estimates are based on current indicative yields of the indices that these funds will replicate; please note that no mutual fund guarantees returns).
- Tax Efficiency: What should also appeal is the level of tax efficiency that the Bharat Bond ETF (like all debt funds) will provide, when compared to bonds. This is because coupons (interest) from the bonds are taxed depending on the investor's tax slab, while bond ETFs are taxed with the benefit of indexation, which significantly reduces the tax on capital gains for investors. Moreover, because of the launch timing, investors can get indexation benefit for one more year – the three-year variant, for example, provides indexation benefit for four years. This will help to increase returns. (Indexation is the process of adjusting the purchase price of an investment after accounting for inflation).
What’s in it for retail investors?
The New Fund Offer (NFO) period for retail investors is week-long, beginning December 13. Individuals can invest in unit sizes of Rs 1000, up to a ceiling of Rs 2 lakh. The question is: is it right for you? Let’s look at the Bharat Bond ETF from a retail investor’s point of view.
To iterate a point, the fund is an initiative to enable retail investors to buy government debt directly, and thereby deepen India’s corporate credit market. Consequently, several carrots have been dangled before the retail investor: the fixed income fund offers a high-quality portfolio, predictable returns, and bare minimum costs. All these factors make the Bharat Bond ETF a good option for fixed income investors.
If you’re a mutual fund investor, you should be happy too, as mutual fund advisors see the bond ETF as an ideal substitute for bank fixed deposits given its better tax-efficiency, as we saw earlier.
To take a balanced approach to the fund, one should try to identify all possible negatives. So, are there any?
Experts foresee minor hiccups on two fronts. First, not all retail investors may have a working knowledge of what an ETF bond is and how it works. Secondly, not all of them may have demat accounts.
However, this should not be a problem. Edelweiss AMC is slated to launch a fund of funds (FoF) on the same day as the ETF launch, enabling investors without a demat account to access the ETF through the FoF, which can be purchased and sold like a regular mutual fund. One can also do a systematic investment plan (SIP) in the FoF.
That apart, experts warn that the long maturity period of the 10-year variant of the Bharat Bond ETF makes it sensitive to interest rate movements. As a result, it could witness a certain degree of volatility in the initial years.
At the same time, it should smoothen out in the long run if one is looking to hold on to it for the entire 10-year duration. Bailing out earlier could lead to losses. Want to understand about tax-free bonds and how they work? Read this.