Most of you may now be familiar with options in the passive equity fund space – both index and ETFs. Today, we have passive equity funds spanning market cap segments, popular sectors as well as common strategies such as value, quality, or low volatility. But the passive debt funds space may still be unfamiliar grounds for most of you.
What are your options today in the passive debt funds space? Are there options across time frames and will it meet all your needs like active debt funds do? This article will take you through this space and gives you pointers on how to make your choices in this segment.
The universe of passive debt funds now
Currently there are 29 passive debt funds. Six of these are fund of funds (which means they are funds that are investing in the ETFs). There are 17 ETFs, 6 FoFs and 6 index funds. The ETFs will have to be bought through your brokerage account. The index funds and the FoFs can be bought like normal mutual funds. You can read about the norms prescribed by SEBI for debt ETFs/index funds here.
Strategy-wise they can be split as under:
- 20 of the 29 funds are target date ETFs or funds – funds that are open-ended but with a fixed maturity date. All of these were launched between the end 2019 and now. They have underlying instruments as gilt or PSU or AAA bonds or SDL or a combination of some of these. We will explain about target maturity funds further on.
- Of the remaining 9 funds, 6 are open-ended gilt funds with no fixed maturity and 3 are liquid ETFs.
Given below is the full list of passive debt funds options today and how they fit into the fund categories mentioned above.
Now, let's get into details about the above categories. The primary focus here is on target maturity funds that account for a majority of the passive debt options today.
#1 Target maturity ETFs/FoFs and index funds
Target maturity funds are funds that will hold a set of instruments whose maturity overlaps with the fund’s own maturity. Since they are passive funds, there needs to be an index that these funds will mirror. So, an index is created for this purpose by index providers. The instruments in the index change only if they fail any of the conditions for them to continue in the index. Such events could result in a rating downgrade or an SDL that is newly qualified in the index and so on.
Target maturity funds are a form of FMP – except that they are open ended, you can enter and exit anytime till they mature. You can learn more about target date funds in an article we wrote when this class of funds first hit our market.
There are few key points you need to understand about target maturity funds presently available in the market:
- Limited time frame and strategy options: Target maturity funds can build portfolios only with instruments of reasonably high liquidity. That means typically higher credit rated bonds such as AAA PSU bonds, other liquid AAA bonds, gilts, or state development loans (SDLs) are the instruments with which these portfolios are built. If this be the case, their maturity is also typically medium to long. Of course, they will naturally be available to you as shorter tenure funds when they are near maturity. For example, the 2023 maturing Bharat Bond ETF will become a very short-term bond when you try to buy it in, say, 2022. Since the landscape is new, we presently have fewer funds/ETFs with shorter residual maturity. So, you will still need to depend on the active mutual fund space for ultra-short options at present. You will also not be able to explore marginally higher credit risk options in the passive space. You presently get that active space even in the short or medium duration categories.
- Cannot respond to interest rate changes: As they are target maturity based – which means buy and hold - the target date indices are not dynamic. And there is another reason for this. In the Indian context, it is not easy for debt funds to mirror an index, given the limited availability and liquidity of bonds. Even target maturity funds have some leeway to hold ‘similar instruments’ if not the same instruments as the index. A theoretically-run dynamic index with many changes may well result in ETFs struggling to mimic the same and may result in higher tracking error. Therefore, you cannot expect these funds to change their maturities based on interest rate scenarios like most of your corporate bond or dynamic bond categories would do.
- Entry point is crucial if held to maturity: if you plan to invest a lumpsum and hold these funds till their maturity, then the fund’s yield at your entry point becomes important. In a regular open-ended debt fund, the scheme can deliver returns (over the yield) with some trading and capital appreciation opportunities, or you can hold them longer over different rate cycles to ensure gains as fund yields adapt to rate changes. But target maturity funds cannot deliver far from their yields (at the time of your entry) if you hold them till maturity. For this reason, attractive yields at the time of your entry is crucial. For example, the Bharat Bond 2023’s yield in January 2020 was 6.75% - a good yield for a 3-year instrument. If you try to enter a target maturity fund now with a 3-year residual maturity such as the Nippon India ETF Nifty CPSE Bond Plus SDL - 2024 Maturity, the yield is at 5.2%. Hence, some element of timing becomes important, unless you know to exit earlier should there be gains from any downward rate cycle.
- Volatility: As is the case with debt funds, target maturity funds too will be prone to notional losses. For example, if the interest rates move up from this point (thus pushing the yields up), the price of the underlying instruments can fall, leading to losses for you. If you hold till maturity, you will not need to fear this.
- Liquidity: The table below will tell you that barring liquid ETFs, trading in other ETFs is not very high. If your investments are not more than a couple of lakhs at a time, then most of the target maturity ETFs will be investible. Otherwise, taking the FoF option or index fund option would be a safer way to invest in this space.
Benefits: The biggest advantage of target maturity funds is that you can align them with your goal if you find one that fits your time frame. Such alignment can be done with other active funds too. But the advantage here is that you can be reasonably sure that the yield at the time of your entry will be your returns (plus or minus a few basis points). This helps plan your goals better. Also, the strict criteria of portfolio building for the present crop of funds ensures that no illiquid or low credit options enter the portfolio.
Performance: While performance data on these funds is very limited, if you compare the medium-term target maturity bonds with maturity of 4 years and above, they compete well with corporate bond funds and gilt funds from the active space and are also beating the latter. Active short duration funds have managed to beat the 2023 and 2025 target maturity funds over a 1-year period.
What might give the target maturity funds an edge in the long term is their expense ratio. At about 0.15% on an average (with nil for the Bharat bonds ETFs and 0.05% for their FoFs), these funds have expense ratios way lower than corporate bond funds (0.52% on an average for September 2021) and short duration funds (at 0.7% on an average).
While the relatively earlier ones like the Bharat Bond ETF do not particularly have low tracking error (relative to equity funds), this is to be expected given that the debt market isn’t as efficient as the equity space. With more funds building a track record, this metric would also have to be watched for. As of now, tracking performance with peers in the active debt space should suffice.
How to use: Performance thus far suggests that these funds appear competitive for 3–7-year time frames over their peers - corporate bond and gilt funds – in the active debt space. But then, data is very limited. Also, this is perhaps the time to remain with shorter tenure funds given the rate uncertainty prevailing, than lock into lower yields now in longer duration. If you enter now and interest rates rise, you might have notional losses. Locking in when rates have moved up a bit will improve your yields and reduce the volatility.
Funds that come with SDLs may offer higher yield opportunities. You can read our strategy on SDLs in this article. You could selectively use them, if you wish, along with active debt funds. Ideally, you should deploy in phases as rates rise. We will be coming up with strategic calls as and when rate cycles lend favour to these products. Do look out for them.
In the other categories such as ultra-short, short, or even floating rate, you will have to tap into the active space.
Interesting fact: You would have noticed that fund houses have come up with their own basket of passive debt funds with varying maturity buckets. This can eventually help create a ‘bond ladder strategy’ – which is the strategy of owning funds with maturities across time frames to reduce the volatility, arising from rate cycle, on your portfolio. More importantly, it reduces the reinvestment risk arising from the maturity of a fund. This works for those looking for predictable returns/income from their debt portfolio. This is a separate topic of discussion and also needs more funds and data in the Indian MF context.
#2 Liquid and gilt ETFs
Other than the target maturity funds, there are 3 liquid funds all of which have reasonable turnover in the market. Earlier, when you were allowed to net your purchase and sales of trading in your brokerage account, liquid funds could be useful to quickly transfer money into stocks when there is a correction. Now, with new settlement norms that require you to have money in your trading account to buy any stock/ETF, there may not be any additional benefit to holding liquid ETFs as opposed to liquid funds.
Also, do note that these liquid ETFs declare dividends every day and reinvest them. Now with dividends taxed in your hands (earlier they suffered DDT), dividend accounting can be a hassle. Also, do note that you cannot compare their NAV returns with liquid funds as the ETF’s NAV would be net of the dividend.
The open-ended gilt ETFs/index funds (other than target maturity) suffer from poor trading (See earlier table on turnover) and they may not be great options at this time. Essentially, this leaves target maturity funds as your primary options in the passive debt space. At PrimeInvestor, we have selectively used passive debt funds in our passive portfolios and have selected ones in Prime ETFs.