The emergence of a new class of ETF in debt

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Please note that the details of the PSU Debt ETF mentioned here are based on reports. There is no official document on the Nifty Bharat Bond index or the Bharat Bond ETF from Edelweiss MF. The idea of this article is to highlight an emerging investment class and its contours based on reported information available.

Owning bonds, unless you are well-diversified, has become a super risky proposition since September 2018. Credit risk and drying up of liquidity have proved to be lethal combinations to manage for investors.

Outside of debt funds, your options to hold a basket of fixed-income instruments are limited. Today, if you want to invest in debt ETFs, you have just 2 options. One is liquid ETFs. The other is gilt ETFs – based on the 10-year G-Sec index and on the 8-13-year G-Sec index. While liquid ETFs have volumes, their return appeal is limited. Gilt ETFs are yet to pick up in volumes and carry volatility and rate risk.

However, when the government decides to make things happen, it can. The ETF space in India turned a little more vibrant with the launch of CPSE and Bharat 22 indices and ETFs based on them.

Now the debt ETF space may receive some life with the soon-to-be launched defined maturity PSU Debt ETF.

Deposits, bonds, funds and FMPs

Let’s look at the typical options for you in debt today, before we go to the proposed ETF.

When you hold deposits, you have a fixed interest rate and fixed maturity. However, you can’t sell your deposits midway. You may have to pay a penalty if you break the deposit. Also, there is the risk of the bank or company not being able to repay you.

Now take a bond. Bonds typically offer higher interest rates than fixed deposits. When you hold a bond there is certainty of a fixed interest and a maturity date. You have the leeway to sell it midway (provided there are takers for the bonds in the market) if you need the money. This may be at a loss or gain depending on the interest rate cycle. However, if you just hold 1 or 2 bonds, you are placing all your eggs in one basket. You run a credit and concentration risk unless you sufficiently diversify, which may be hard to do.

Next consider open-ended bond fund from a mutual fund house. In a bond fund,  you hold a large basket of several bonds with varying interest ad varying maturities. The fund by itself doesn’t have a maturity. The fund will hold instruments that mature or are sold but are always replaced with other bonds. This will be an on-going process.

But since there is no maturity and the underlying instruments are not fixed, you don’t know the interest rate or tenure for certain; i.e., you are left to wonder what your return could be.. If you align your investment to the maturity of the fund at the time of your investment, chances are, you will get the yield sported by the fund at the time of your entry. The positive aspect is that you can sell when you need the money. They are more tax efficient than deposits if held for over 3 years.

 Fixed maturity plans or FMPs from mutual funds are a kind of mid-path between bonds and an open-ended bond fund. FMPs simply buy and hold instruments whose maturities are the same as that of the FMP. In other words, if you held several bonds and held them till their maturity, that would be like an FMP, in a simplified way. Here, you get a little more certainty on the returns because you know the same instruments are going to be held till the FMP matures. It is also tax efficient as capital gains benefits are available for over 3-year periods.

Both FMPs and bond funds still carry credit risk although the diversification reduces it as opposed to holding individual bonds.

A maturing ETF

Now, the above investment options have some limitations or the other. Those that offer you fixed interest and maturity do not provide liquidity (deposit, FMP) or have higher risk (bond) unless diversified. Those that are well diversified (bond fund) and offer liquidity do not provide certainty of return. This is where a defined-maturity ETF can fit.

A defined maturity ETF will be a basket of debt instruments with a fixed date of maturity. Its instruments will be bought and held till maturity. The ETF will be traded on the exchange to provide you with an exit, when you want, before the maturity date. You can also buy them on the exchange after the NFO. Since the instruments don’t change, you will know that the returns you will get will roughly be the interest or yield of the underlying instruments, if you hold them through the tenure. These ETFs will be taxed like debt funds, enjoying capital gain indexation benefit if held for over 3 years.

This kind of ETF is very similar to an FMP, except that it is expected to be more liquid.

The Bharat PSU ETF

Edelweiss has filed for a defined maturity ETF that will invest in AAA-rated PSU bonds with a fixed maturity. This will be India’s first maturing ETF as the current gilt ETFs do not have a defined tenure. The ETFs are expected to come in 2 maturity buckets – 2023 and in 2030. As and when they mature, newer ETFs with different maturities may be issued.

This ETF will stand out for several reasons:

  • One, it is an ETF that matures. Hence you reduce market risk if you hold the ETF till maturity. You will get the principal plus the interest (that is reinvested as and when received) at the end of the tenure.
  • Two, it is widely expected that they will be liquid enough (as was the case with PSU equity ETFs) as the government will push for retail participation, besides generating institutional interest.
  • Three, since these will be PSU bonds, the credit risk will be almost nil as PSUs are government backed and liquidity risks may also be limited.
  • Four and very importantly, the ETF cost is expected to be so low that a well-managed bond fund with just an all PSU portfolio may find it hard to beat this ETF, post expenses.

However, wherever there is a maturity, there is a reinvestment risk – the risk that you may get a lower interest rate if you reinvest your money after maturity. While there are strategies to overcome this if you hold a series of ETFs with different maturities (like mutual funds do by holding bonds with varied maturities), the safest way to avoid reinvestment risk is if your own goal is aligned to the ETF’s maturity.

We will be covering more on this ETF once details are officially out and let you know where it will fit in your own portfolio. However, we think in the current Indian debt market, defined maturity ETFs are a better approach in the debt ETF space. This is simply because there isn’t an efficient way in which one can build a perpetual debt ETF given the current liquidity and valuation scenario in the Indian debt market.

In fact, a recent circular by SEBI spelling norms for debt ETFS and debt index funds expects a scenario of ETFs not being able to mimic the instruments in the index; the circular allows the ETF to deviate up to 20% from the original index. This, in our understanding given the limited information available, seems more like an active strategy than passive.

As more information becomes available, we will be able to weigh the benefits and risks of debt ETFs in a better manner. At this point, it is useful to know that the debt landscape is slowly seeing a change and you may have a larger variety and better strategies in the fixed-income space that you can choose from.

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7 thoughts on “The emergence of a new class of ETF in debt”

  1. Given the way the rating downgrades have taken place in recent times and that too after the default, I am not able to buy the hype associated with AAA rated bonds. Moreover, this govt has a clear roadmap of selling PSUs every year to meet the fiscal target. So, what happens to these AAA rated bonds issued by a PSU that gets sold to a private entity? It doesn’t remain default-proof. Your take.
    Regards,

    1. Vivek,
      Can you name any PSU that became a private entity (other than bank takerovers due to distress) in the recent decade. If it happens it is an extremely slow process simply because a good number of them are quality companies that the government wouldn’t want to lose. And if you know the kind of companies in Bharat bond index, you’ll know why. So chill. If one owns PSU bonds now, they are government backed. That is sufficient comfort. Vidya

  2. Hi, Very informative. Please do a thorough analysis after details are out. Looking forward to your guidances in debt investing which is little understood and more complex vis-a-vis equity investing. Regards.
    Swaminathan V

  3. Hi Vidya
    In Fixed Income basket, in addition to FDs, I invest in debt MF, so that I pay tax only when I withdraw. But the problem is, some debt MF gives very low return compared to FD and I am forced to liquidate without necessity. Debt ETF will be quite useful. Thanks for the nice article. Keep writing more on fixed income space since most of the analyst touching only equity
    N Sankar

    1. Will do sir. Thanks. Please follow us and subscribe. We will be providing recommendations across personal finance products and also provide appropriate debt fund calls and let you know when to stay and when not to.
      regards
      Vidya

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