What makes Bharat Bond ETFs a good option for buy-and-hold investors

Holding them till maturity will take care of interest-rate and liquidity risks that may exist

The Union Cabinet has given its go-ahead for the launch of India’s first corporate bond exchange-traded fund (ETF). It will be called Bharat Bond ETF and will consist of AAA-rated papers issued by government-backed companies. Edelweiss Asset Management will manage the first tranche.

The base size of the issue will be Rs 7,000 crore and it will be extendable to Rs 15,000 crore. Two ETFs – one investing in three-year paper and the other investing in 10-year paper – will be launched. A fund-of-fund option will also be made available.

The ETFs will have a target maturity structure, not an open-ended one. The three-year ETF will mature in April 2023 and the 10-year product in April 2030. These ETFs will be growth products (and will not pay interest).

Passive, low-cost advantage: In India, a lot of debate has taken place on active-versus-passive fund management in the context of equity funds, but not so much in the context of debt funds. “The passive approach is actually more relevant to debt funds as this is not an alpha-generating asset class,” says Radhika Gupta, chief executive officer, Edelweiss Asset Management. Hence, the investor may as well go with a passive product where he gets the benefit of low cost. The expense ratio of this product is a minuscule 0.0005 per cent. “In debt funds, the returns are lower than in equity funds, so any saving on cost adds to the investor’s return,” adds Gupta.

A transparent product: The investor will know the constituents of the index before he invests. Given the spate of corporate defaults, starting from the latter half of 2018 – many active debt fund managers were caught holding those papers that defaulted or were downgraded – investors today want the comfort of knowing beforehand where their money will be invested. The yield on the index will be published every night (on bharatbond.in).

Since the index will consist of AAA-rated central public sector enterprises (CPSEs), these ETFs will carry a low level of credit risk. “The credit risk will be negligible here,” says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor.

These ETFs will also help investors mitigate reinvestment risk. “Whenever an investor finds the yield attractive, he can lock into this ETF for 10 years, thereby reducing reinvestment risk in his portfolio,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

The taxation of these ETFs will be more favourable than that of bonds and fixed deposits. In the latter, the interest that is paid out gets added to the investor’s income and is taxed at the marginal income tax rate. This hurts investors in the higher tax brackets more. Here, the investor will be taxed at par with debt mutual funds—at the rate of 20 per cent with indexation if he holds the ETF for more than three years.    

Watch out for liquidity risk: Gupta say that the issue is large, the constituent bonds are liquid, and market makers have been appointed. New tranches will be launched periodically. All these factors, she says, will result in good liquidity on the exchanges. Market experts, however, are a little sceptical on this count. “We will have to wait and see how liquidity pans out in this product. The bid-ask spread on it will also have to be watched,” says Rajesh Cheruvu, chief investment officer, Validus Wealth.

In case of low liquidity, retail investors will be better off taking the fund-of-fund (FoF) option, where redemption will be available through the AMC. The expense ratio of the FoF will, however, be higher.

These ETFs will also carry interest-rate risk. It will be higher in the 10-year ETF and lower in the three-year ETF. The investor can overcome this risk by holding these ETFs till maturity.

While credit risk will be quite low here, it may not be zero. “The government may not allow these companies to default. But there is always the possibility of these bonds being downgraded, which could have a mark-to-market impact on the portfolio,” says Dhawan.  

Buying an ETF will entail paying a brokerage fee. “If the brokerage fee is 50 basis points, that would be considerable in the context of a debt ETF,” says Raghaw.  

What should you do? 

This product is suitable for an investor who wants a low credit risk product for his debt portfolio. “Investors who do not understand the risks in debt funds, find it difficult to select the right category and fund manager, and want a medium- to long-duration product, may invest in these ETFs,” says Raghaw. It is not for investors who want regular cash flows. Those who wish to circumvent interest rate and liquidity risk should adopt the buy-and-hold strategy. “Those who do not have a demat account or want to circumvent whatever liquidity issues may exist should go with the fund-of-fund option,” says Dhawan. If you take the ETF route, use a low-cost broker. Check the yields on the web site, see if they compare favourably with other debt products of similar maturity on a post-tax basis, and then invest.