On 4 December, the government of India unveiled the Bharat Bond Exchange Traded Fund (ETF). It is a fund that will invest in central public sector enterprises, tracking the Nifty Bharat Bond Index. The ETF will have two target maturities of three years and 10 years each. You can buy units for as little as 1,000 and it is slated to have an expense ratio as low as 0.0005%. Being an ETF, after the NFO (new fund offer), its units can be purchased and sold on a stock exchange. The units will be held in your demat account.

An ETF is a passive mutual fund product which replicates an index; there is no selection by a fund manager. In return for giving up the chance to outperform the index, ETFs come with lower costs. In India, debt ETFs must have at least eight issuers and no single issuer can account for a weight greater than 15% (read more about the debt ETF structure in India.)

The three-year Bharat Bond ETF will hold the debt of 13 public sector companies like National Highways Authority of India (NHAI), Indian Railway Finance Corporation (IRFC) and Power Grid Corporation of India. The 10-year Bharat Bond ETF will hold the debt of 12 public sector companies such as Rural Electrification Corporation (REC), National Bank for Agriculture and Rural Development (NABARD) and Power Finance Corporation (PFC). Only AAA-rated debt issued by the PSUs will be included in the two ETFs. However, Radhika Gupta, CEO, Edelweiss Asset Management Co, which is managing the ETF, said that the scope may be expanded to AA-rated debt in the future for other ETF tranches.

The tax edge
The tax edge

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A Bharat Bond ETF will be managed in a manner similar to a fixed maturity plan (FMP) but with the liquidity of an open-ended fund. It will hold bonds to maturity and hence, you will lock-in the yield prevailing at the time of investment. For example, the current yield on three-year and 10-year CPSE bonds are about 6.5% and 7.5% respectively. This structure also avoids interest rate risk, which characterizes open-ended debt funds. However, note that this is only true if you hold the ETF to maturity. While the net asset value (NAV) of the scheme will react to changes in interest rates, this will not impact the investor who is holding the units to maturity. On maturity, the bonds held are redeemed and funds paid out to the unitholders. The AMC plans to launch fresh ETFs in succeeding years giving investors access to different tenors, said Gupta. Thus for example, the maturity of the first two Bharat Bond ETFs will fall from 10 years and three years to nine years and two years after a year’s time. However, a fresh ETF launched by the AMC next year will have maturities of 10 and three years, Gupta added. Hence, over time, investors with widely differing time horizons will be able to meet their requirements through the ETF.

For those who do not have a demat and trading account, Edelweiss AMC will be launching a fund-of-funds (FoF) on the same day as the ETF launch; so one can get access to the ETF through the FoF, which can be purchased and sold like a regular mutual fund. You can also do a systematic investment plan (SIP) in the FoF.

Advantages

The single largest advantage of the ETF is the tax benefit. Debt funds are taxed at slab rate for holding periods of less than three years and at 20% with indexation for longer holding periods. This confers a major advantage on the ETF compared to fixed deposits in banks. Another big advantage is the maturity structure, which lets you lock-in yields if you hold the ETF to maturity. Ordinary debt funds also have the same tax treatment as this ETF but they lack the ‘target maturity’ structure of the ETF. In a target maturity structure, the maturity of the holdings of the ETF keeps reducing over time in line with the reducing tenor of the scheme. As a result, the risk of loss in the value of bonds from interest rate hikes comes down for investors who may enter the scheme at any point provided they hold the units to maturity. In addition, there will be virtually no credit risk as the debt in the ETF is issued by public sector companies. The 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. “I would recommend the 10-year ETF rather than the three-year one," said Feroze Azeez, deputy CEO, Anand Rathi Pvt. Wealth Management. “Investors in that variant can pocket gains from further rate cuts and compression in the term spread of 1% over time," he added. The term spread is the higher yields that longer term bonds contain because of their higher risk. As the maturity of these long dated bonds comes closer, the yield decreases accruing gains to investors. In case of open-ended debt funds, the return fluctuates continually by interest rate risk and credit risk.

Another big advantage is the liquidity. FMPs, which are a kind of debt fund, enjoy both the tax and target maturity advantage. But they are not liquid. FMPs are open for subscription for a limited period and mature on a particular day. In theory, you can buy and sell their units on a stock exchange but liquidity tends to be very poor. With Bharat Bond ETF, you can not only enter and exit on any trading day but also at different points during a trading day. Edelweiss AMC has engaged market makers (entities which buy and sell ETF units for a small profit) to ensure adequate liquidity. FMPs also take exposure to riskier papers and have been hit by recent defaults in companies like DHFL.

Downsides

Although you will get the yield prevailing at the time of investment if you hold the ETF to maturity, its NAV can fluctuate on a daily basis due to interest rate movements as debt paper is marked-to-market. In addition, the market price (as distinct from the NAV) can also fluctuate on account of liquidity or lack thereof. For most retail investors, market price matters as they will be transacting the units on a stock exchange rather than directly with the AMC. You have to be prepared to ignore this volatility. If you have to exit the fund before maturity, you may have to take a loss on account of this fluctuation.

In addition, the ETF may not be liquid enough to allow you to actually execute transactions. Transacting with the fund house can only be done in lots of 25 crore; so in most cases, you will have to buy and sell from the stock exchange. “It has a good product construct," said Gaurav Awasthi, senior partner, IIFL Wealth Management Ltd. “But it remains to be seen whether there will be enough liquidity on the stock exchanges. For retail investors, the FoF route will be the best option," he added.

Mint Take

This is a good product for investors seeking low risk, predictable return and reasonable level of liquidity. However, some of these properties such as liquidity can only be known once the ETF actually starts trading. In addition, the government’s disinvestment needs mean that some of these companies may not remain PSUs in the future. The consequent rebalancing will raise costs and affect returns in the ETF. Finally, interest rates in India are close to a multi-year bottom (the RBI’s repo rate is at a nine-year low) and hence locking yourself in at these levels may not be very rewarding. If you are really keen on investing, spread out your money via SIPs.

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