ETF stirs Bharat’s bond market


The Bharat Bond ETF could help bring in retail investors in India’s bond market.

Source: Tavaga Research

The world of fixed income investment products in India is about to be stirred with a new entrant — the Bharat Bond ETF. It is India’s first bond ETF and is set to open for the public in a new fund offer (NFO). The Bharat Bond ETF launch date is December 12, and the NFO will continue till December 20.

The Bharat Bond ETF is significant for quite a few reasons, leading to a much-deserved buzz in the run-up to its NFO.

It is the latest investment fund (pooled funds) in passive investing, a term that is still new to many a retail investor. But Bharat Bond ETF could usher in greater awareness about bond ETFs, ETFs in general and passive investing.

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What is an ETF 

An ETF is an exchange traded fund, which is a kind of investment fund that trades on the bourses, after its NFO. ETFs are one of the defining instruments of passive investing, characterised by returns from benchmark-tracking and low operational costs.

Bharat Bond ETF details

Edelweiss is the asset management company that will be launching the ETF, which will invest in bonds issued by government enterprises such as NHAI, Nabard, Hudco.

A study of Bharat Bond ETF explains what is a bond ETF and how to invest in a bond ETF.  Bharat Bond ETF, just as all bond ETFs, takes the bonds offered by companies and creates a basket of those securities for the pooled investments to buy smaller units of.

The Bharat Bond ETF will invest in the debt-papers issued by the central public sector enterprises (CPSEs), with a credit rating of AAA, considered to signify good quality. 

The fund will have two variants, dictated by the maturity or tenures. There will be issues for three years (weighted average maturity of the portfolio is three years) and 10 years (weighted average maturity of the portfolio is 10 years).

The fund house plans to launch a fresh ETF with three- and 10-year maturities, while the maturity on 2019’s units will drop by a year by that time. 

Bond investment
Source: Tavaga

Income on Bharat Bond ETF

There are two ways a retail investor may earn by investing in bond ETFs, including the latest entrant.

The two tenures being offered come with interest rates get locked in at the time of picking up the NFO. The yield on three-year (around 6.59 percent) and 10-year (around 6.52 percent) CPSE bonds at the time of buying the ETF units will be the interest rates realised at redemption, should we hold them till maturity. 

The bond ETFs will behave like fixed-income instruments only if held till maturity because if we sell the ETF units midway, the earnings realised will be according to its Nav or its market price, depending on who we sell to. 

If we don’t see the tenure through, there is the option of selling the ETF units on the secondary market, and receive their market price in exchange. 

Bharat Bond ETF advantages

A Bharat Bond ETF-review will show that there are a few things going for it, making people sit up and take notice. We list them out:-

Tax benefit – Bond ETFs are tax-efficient. The Bharat Bond ETF is no different as it is being taxed the same as debt funds. If held for less than three years, the returns on the ETF units will be taxed at our tax-slab rate. If we hold the units for longer than three years, the returns will be taxed at 20 percent but after factoring in the indexation benefits (inflates the purchase price, lowering tax liability).

In fact, Bharat Bond ETF has an advantage over equity ETFs in which the underlying securities are private companies. Such equity ETFs are taxed like equity shares, attracting short-term capital gains tax on returns on units held for less than a year and long-term capital gains tax on returns on units held for over a year at 10 percent for gains over Rs 1,00,000, without indexation benefits.

Expense ratio – The expense ratio of the fund will be around 0.0005 percent, which is uber-low compared to investment funds like mutual funds. The Bharat Bond ETF, after all, is a passively-managed fund that does away with the need for active intervention by a fund manager.

Low-risk – If we hold the units till maturity, we essentially have a low-risk, fixed interest investment on our hands. The rate of interest does not change and we are owed redemption once our tenure ends.

Credit of issuers– As the tables below, with the constituents of the two variants of Bharat Bond ETF show, the CPSEs whose debt-papers are the underlying assets for the ETF are highly graded (AAA ratings) for credit-worthiness.

The constituents of the Bharat Bond ETF for three years are:- 

Bharat bond ETF April 2023 constituents
Source: Tavaga Reseach

The constituents for 10-years Bharat Bond ETF are:- 

Bharat bond ETF April 2023 constituents
Source: Tavaga Research

An analysis, by a rating agency, Crisil, of the ratings over five years of all the bonds in the tentative portfolio of the Bharat Bond ETF shows almost all of them to be consistent at AAA.

Bharat Bond ETF: How to apply

A retail investor looking to subscribe to the Bharat Bond ETF may go to the Edelweiss website, to their office or their brokers to apply for it between 12 and 20 November, 2019.

If buying the ETF units, we would need a Demat account. If we opt for the fund of funds (FoF) that Edelweiss will launch for the same, the mutual fund units won’t need a Demat account. The FoF will also allow us to go the Sip route in the product. 

Bharat Bond ETF price

During the NFO, investors can invest with either just Rs1,000 or its multiples.

Once the NFO is over, the ETF units will get listed on the exchange and the market price will get revealed then. We may pick up the units available for trading on the exchanges, as well.

Bharat Bond ETF review for the retail investor

While the product is one to consider for a retail investing portfolio, there are also some drawbacks which we must be aware of before taking a call:-

Unit selling price — ETFs are passive funds, and their units cannot be sold back to the fund house in retail values, even though they are open-ended funds. Either market makers or traders on the stock exchange (BSE and NSE in this case) can buy back (or sell) ETFs units after their NFO. 

ETFs’ Nav, then, is not the same as the market price, unlike with MFs. While the Nav, which is affected by the prevalent interest rate as debt-papers or bonds are marked-to-market, is the price an AMC buys back ETFs for, it is not relevant to retail investors like us. AMCs transact in ETFs in tranches of Rs 25 crore, beyond the scope of a regular net-worth investor.

We need to remember, then, the factor affecting the market price — the liquidity of the ETF.

Liquidity in debt ETFs — Given the nature of debt ETFs where holding till maturity if the locked-in interest is good deters potential sellers from trading on the exchange, debt ETFs have often suffered from liquidity crunch or a low trading volume. Hence, the market price for such products tends to be steep for buyers on the secondary market. For a seller, too, it might result in a large impact cost if buyers shy away.

With Bharat Bond ETF, the AMC has tried to keep the ticket price low at Rs 1,000, seen as a move to spur liquidity in the ETF’s availability.

It has also roped in market makers to ensure liquidity prevails. Besides, the plan for subsequent launches of more units, boosting the supply of the product, will enable investors to buy into the ETF at various stages of its maturity.

Current interest rates — Interest rates, and yields, in the country are at one of their lowest. The repo rate is at a nine-year low (at 5.15 percent).

Historical Repo rate
Source: Tavaga Research, RBI

The timing of the launch could mean we lock ourselves with a not-so-lucrative rate, which could lead to regret later. 

We could wait for next year’s release of new units (interest rates may have moved up by then) or we could buy into the fund of funds (FoF) offer that will be floated along with the ETF. The FoF option, behaving like an MF will leave us an option to sell units back to or buy new units from the AMC at Nav (affected by the prevalent interest rates), without getting locked in at low-interest rates. The income on the FoF units will be similar to MF returns. 

CPSEs — Underlying securities from CPSE may have a flipside too, which is not yet apparent. Albeit the ratings of the constituents of the Bharat Bond ETF are above suspicion, but rating agencies are not always foolproof in their assessment. The debacle of DHFL, the small-housing finance company, and its inability to redeem its debt-papers underlined the lag credit agencies have in their ratings. It was only after the default, that the agencies scrambled to downgrade the firm’s credit-worthiness, and that too was done in a staggered way at that time. Hence, we should not get too complacent with such ratings.

Moreover, with the central government’s push towards disinvestment from time to time, some of the constituent CPSEs could get privatised. The ensuing portfolio readjustments in the ETF may cost unit holders additional fees or performance lag (such as tracking error) at the time. 

Bharat Bond ETF vs FDs

The Bharat Bond ETF is expected to give a tough time to some old-school fixed income instruments such as bank FDs (fixed deposits)

That is because, despite falling interest rates affecting both FDs and bonds, bonds with an AAA rating have outperformed the returns from the term deposit rates in the last five fiscals, according to Crisil. 

Comparison of AAA rated bonds with FD rates

Source:  Crisil research

Regulatory boost to bonds

Missing G-Sec — Globally, the bond market plays a key role in financing projects for the long run such as infrastructure and scaling up of corporations. 

But India’s corporate bond market is fraught with a “fragmented yield curve”, according to Sebi Chairman Ajay Tyagi, and is far from being a mature one. 

The absence of government bonds or government securities with wide-ranging tenures makes corporates shy away from launching diverse yield products for want of a sturdy benchmark. 

Instead, most bonds are available with a three-five-year and a 10-year maturity, since government securities are available for benchmarking these yields. 

A continuous yield curve would need the government to introduce bonds with different maturities than these three options, and it would lead to greater liquidity and lower impact cost for the trader.

The Bharat Bond ETF will surely be a catalyst for the market with its benefits but more proactive involvement of the government is required to smoothen out the bond market.

Sebi’s new norms Sebi laid out new mandatory norms for debt ETFs and index funds on November 29, geared to bring in robustness and stability to such products. They are:-

1.       The debt ETF or index fund provider has to have at least eight different issuers in the fund; the rationale is diversification across different companies.

2.       The debt ETF or index fund provider cannot assign more than 15 percent weight in the portfolio to a single issuer.

3.       The debt ETF or index fund provider will only invest in issues with an investment-grade rating (‘AAA’,’AA’, ‘A’ and ‘BBB’ are considered as investment grade ratings).

In case the rating falls below investment grade for an issuer, the provider has five working days to rebalance the fund portfolio. 

4.       At the aggregate portfolio level, the duration of the fund should not deviate more than 5 percent from the duration of the benchmark index; the rationale for any deviation needs to be recorded.

5.       All the existing debt ETF or index fund providers will have to adhere to these norms and have to rebalance their portfolio within a period of three months from the date of issuance of Sebi’s circular, dated November 29, 2019.

The Bharat Bond ETF has regulatory reinforcements going for it, as also tax benefits. As a fixed income investment option, it does well to hold its ground against popular products like bank FDs. As for trading volume, we would only get to know once it lists on the bourses.

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