Fixed income. An asset class traditionally close to Indian hearts. Long before the arrival of the equity cult in the country, bank deposits remained the vehicle of choice for generations. From our parents to grandparents, the humble, simple and straightforward FD was synonymous with both savings and investments.
Today, as Edelweiss AMC launches India’s first-ever PSU bond ETF, the big question is whether this new concept will be able to claw some of those savings out of traditional fixed deposits into market-linked bonds.
The timing is interesting. The Bharat Bond ETF comes after 15 bruising months of debt market chaos triggered by the IL&FS collapse in September 2018. That was the time when debt funds were being aggressively sold in the market as a better and more tax-efficient alternative to FDs.
While that is true, it is only the partial truth. What AMCs, their distribution chains and financial advisors, forgot or perhaps chose to not highlight was that a debt mutual fund also carries an underlying market risk—either credit risk, or interest rate risk or both.
Financial products sold only with the promise of high returns without explanation of underlying risk, in my mind, amounts to mis-selling. But let’s not put the blame entirely on mighty mutual fund houses and distributors – most investors also never bothered to ask about risks or educate themselves about the product. So when the debt default malaise started to spread like a virus, many investors encountered their first -ver NAV hit or faced a situation where their fixed maturity plan couldn’t meet the promised payout.
The fixed income market has come back from that brink. But not entirely. And the launch of the Bharat Bond ETF is going to be critical in rebuilding some of that lost confidence.
A CPSE bond ETF: The working
For starters, the product at least does not have the headache of high credit risk as this is an exchange-traded fund which will invest only in bonds of government-owned companies or CPSEs. So the sovereign backing goes a long way in ensuring peace of mind in the era of corporate defaults.
Secondly, Edelweiss AMC, which is launching this ETF, has decided to opt for a ‘Target Maturity’ model. This means that the fund will hold bonds maturing in a specific year. In this case, there are 2 different ETFs being launched with two different target maturities—the shorter one matures in 2023 and the long-term one matures in 2030.
The advantage of following the target maturity model is that it reduces the interest rate risk associated with any debt fund investment. If you hold your ETF investment till maturity, it will pretty much work exactly like holding a bond or investing in a fixed deposit, where the money is withdrawn only at the end of the maturity period.
According to Edelweiss AMC, the indicative yield of the underlying Bharat Bond Index 2023 is 6.69 percent. The prevailing rate on a 3-year SBI Fixed deposit is 6.25 percent. Add the tax benefit, which debt funds enjoy over FDs, (debt funds are taxed at 20 percent with indexation after 3 years while FDs are taxed at the slab rate), and the Bharat Bond ETF does start to look compelling.
“It’s a ‘no-brainer’ alternative to FDs for investors in the higher tax bracket,” says Motilal Oswal Pvt Wealth’s Ashish Shanker.
Bharat Bond ETF: Market volatility
While the Bharat Bond ETF will work like a fixed deposit or an FMP (fixed maturity plan), it does offer investors the option to exit before maturity by selling the ETF units on the exchange. And here’s where some important points come in if you are selling or buying ETF units in the market. For one, the ETF’s NAV will reflect daily market volatility i.e if the price of a bond held by the ETF falls or rises in the market so shall the fund’s NAV.
Another important aspect is the variation in the NAV and the market price of the ETF. The market price of the ETF will vary depending on the demand for the ETF. If a lot of buyers queue up, the market price of this product could be higher than NAV and vice versa if there are a lot of sellers- just like what we see in any other listed share or security.
“The difference between the NAV and the market price has been as wide as 20 percent in some illiquid bond ETFs in the past. One hopes that will not be the case in the Bharat Bond ETF,” says Deepak Shenoy of Capital Mind.
It’s a valid point because buying ETF units, which are trading much above the fund’s NAV, won’t make much sense for investors. Hopefully, this will be addressed by ensuring adequate liquidity in the market.
The other aspect Shenoy cautions about is the concept of zero credit risk. “Let’s not forget that even stressed government companies can get downgraded. And if that happens, the ETF will have to take a mandatory mark-down,” he said.
According to Sebi rules, if debt paper is downgraded by a ratings agency, a mutual fund must mark down the value of the security by 50 percent in case of a non-finance company and 75 percent in case of a finance company,
It is useful to keep these factors at the back of the mind and invest with eyes wide open. The caution and market mechanics aside, there is no denying that the Bharat Bond ETF perhaps merits a serious look for those willing to stay the course and hold their investment till maturity.
The 10-year option gives an indicative yield of 7.58 percent, which, according to experts, could translate into a 6.5 percnet to 6.75 percent post-tax return, assuming inflation runs at 4 percent.
In an environment where interest rates may soften even further, it may be worthwhile to lock in good yields wherever they are available. The advantage of an ETF is its low cost. In this case, that cost is as low as 0.0005 percent vs the average expense ratio of 0.75 percent to 1 percent for most debt mutual funds.
The catch, however, is that you must have a demat account to invest in an ETF. For retail investors who do not have a demat account, Edelweiss is also launching a fund of funds through which exposure can be taken to the CPSE Bond ETF.
The Bharat Bond ETF marks an important milestone in the Indian fixed income market. It is yet another attempt to deepen the corporate bond market of the country and increase retail participation and liquidity. The coming days will determine how much of a success this attempt is going to be.
First Published: IST