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Business News/ Mutual Funds / News/  Should you go for Bharat Bond ETFs instead of FDs?

Should you go for Bharat Bond ETFs instead of FDs?

The ETF’s ‘target maturity strategy’ works best for the conservative part of a portfolio
  • Liquidity will be an important aspect if you want to trade in units of Bharat Bond ETF in secondary market
  • Open-ended debt funds follow a similar maturity strategy, and provide unhampered liquidity (Photo: iStock)Premium
    Open-ended debt funds follow a similar maturity strategy, and provide unhampered liquidity (Photo: iStock)

    The launch of the Bharat Bond ETF (exchange-traded fund) has brought one more fixed-income investment option to Indian investors. The product addresses the three main things that investors look for in fixed-income products—assurance of return of capital, predictability of returns from the investment and a fixed tenor.

    So far, bank fixed deposits (FDs) and small savings schemes have been the go-to products in this category, but they are hindered by issues of lower returns, limits on the extent of investments, inflexibility and illiquidity. We tell you if the Bharat Bond ETF meets these needs, and also tell you about other similar options in the market.

    Safety, predictability

    Bharat Bond ETFs take care of the safety feature by building a portfolio of AAA securities issued by government entities. This eliminates credit risk or the risk of default.

    The other two requirements are met by its target maturity structure, which is similar to the structure of fixed maturity plans (FMPs)—the Bharat Bond ETF has a fixed term and the portfolio holds securities that match the targeted maturity of the fund. The securities mature around the time that the tenor of the fund comes to an end and the fund collects the redemption proceeds from the bonds and pays off the unit holders.

    Since the ETF will hold the bonds to maturity and the coupon income and redemption value are known, you can estimate its yield at the time of investment. While the net asset value (NAV) of the fund will fluctuate during the period to maturity in response to changes in interest rates, it will not affect the yield if you hold the units to maturity.

    The ETF’s structure allows you to buy its units in the stock markets even after the new fund offer (NFO) closes. In this case, you will get the yield for the remaining period to maturity. Say, if you buy the three-year ETF after one year has elapsed and two years are left to maturity, you will get the yield relevant for the remaining two-year period. The price at which the units are available in the market will adjust to reflect the current yield. If the ETF issues additional units, the fresh funds will be invested in bonds of the same tenor as that of the ETF; in the above example, in bonds with a tenor of two years. In this way, the ETF is able to give you a visibility of the yield, even if you don’t invest during the NFO period.

    Like FMPs and other ETFs, the Bharat Bond ETF provides liquidity by listing the units on the stock exchanges. Unlike FMPs, ETFs have market makers called authorized participants (AP) who provide buy and sell quotes in the market for investors to sell or buy additional units, thus ensuring adequate liquidity. But so far, the experience with ETFs listed in the Indian markets has not been positive on the liquidity front, as the prices at which ETFs quote and trade are at significant variance to the fund’s NAVs. This means that investors will be buying at prices much higher than the NAV and selling at prices lower than the NAV.

    “We have kept a very high threshold for institutional investors to come to the AMC at 25 crore. In past issues, this limit was 50 lakh and no one went to the market maker. We have also agreed on the spreads that the market maker will charge," said Radhika Gupta, CEO, Edelweiss Asset Management Ltd, on the steps being taken to make the market making more efficient. “The market maker can come to the AMC every time there is 1 crore of inventory. This will bring down the cost of holding inventory as will RBI’s directive that the units of debt ETFs are eligible securities for repo transactions," she added.

    It remains to be seen if you, the investor, will experience the ease of trading in units that the issue promises. If you are allotted units in the NFO and intend to hold it to maturity, this may not matter. But if you are seeking to accumulate the units over time in the secondary market or want to sell to capture a gain in the NAV on account of an interest rate fall, lack of liquidity might be a concern.

    The Open-ended Option

    If unhampered liquidity is your primary concern, you can look at open-ended debt funds, which are a refinement on the ETF format and follow a similar maturity strategy in their portfolios. These open-ended funds invest additional inflows from the issue of fresh units in bonds that reflect the residual tenor of the targeted maturity. In this way, they are able to give a visibility of the yield to investors who hold the units for that tenor.

    Open-ended debt funds with targeted maturities tick the boxes of visibility of yield, protection from interest rate risk and liquidity. “In an ETF, the index committee will decide on the securities and their weightage. The ETF fund manager has limited say in the portfolio and this can be an issue over a long period. In an open-ended structure, the fund manager has greater control and the investor has greater visibility. The fund managers are not restricted only to PSUs and have a portfolio that is more diversified and can potentially give higher yield," said R. Sivakumar, head, fixed income, Axis Mutual Fund. Edelweiss 10-year Gilt Fund, Axis Dynamic Bond Fund, DSP Savings Fund and DSP Corporate Bond Fund are some of the open-ended funds that use this strategy.

    The success of a target maturity strategy depends on the ability to invest at different tenors as the maturity rolls down. The Bharat Bond ETF ensures adequate supply of bonds by tying up with government entities for continuous supply in the primary market across tenors. The issuers are also expected to simultaneously issue bonds to other investors to maintain adequate supply in the secondary markets if the ETF has to buy bonds to back fresh issue of units. But this may not be true for other open-ended funds which don’t have a defined pipeline for bonds. “Indian bond markets are not liquid except in specific segments like the 10-year one. This will be a challenge for other issuers of such products," said Sivakumar.

    What it means for you

    The target maturity strategy is suitable for you if you are looking for a fixed tenor and assurance of yield. The portfolio of bonds of government-backed issuers will protect you from default, albeit with some sacrifice on returns.

    With better returns and a tax advantage, the Bharat Bond ETF and other mutual funds following this strategy score over FDs. The gains will be taxed as long-term capital gains after availing indexation benefits. Over a longer investment period, the benefits of indexation to reduce tax incidence can be significant. The interest earned on FDs, on the other hand, will be taxed at your marginal rate of tax.

    The Bharat Bond ETF is expected to later have follow-on issues in the existing issue as well as fresh issues of 10-year and three-year maturities.

    Such products allow you to ladder your fixed-income holdings. In other words, you can hold products of varying maturities and lock in yields for different tenors.

    A roll down strategy ensures that you don’t need to move your money to low-volatility funds and products as your goals come closer; the fund will do the job by adjusting its maturity accordingly. The portfolio of the 10-year Bharat Bond ETF will essentially look like that of an ultra short-term debt fund 90 days before the end date and will have very low volatility.

    However, investors in funds with such a strategy will see limited gains from any softening of interest rates since the maturities of the securities reduce with time. “There is no opportunity to play the rate cycle given that it is a fairly long holding period—of over three years or over 10 years. If you look at three-year rolling periods, most of the times actively-managed funds have been competitive relative to passive products like closed-end funds such as FMPs," said Sivakumar. “The interest rate risk is apparent over the short term. Over long holding periods, the volatility comes down significantly and the impact of interest rate risk on returns comes down," he added.

    Investors should ideally consider funds with this strategy only for the conservative portion of their fixed-income portfolio.

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    Published: 16 Dec 2019, 08:57 PM IST
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