Prime Review: Should you invest in Bharat Bond ETF?

The NFO of the latest tranche of the Bharat Bond ETF – a portfolio of high-quality PSU bonds from the Edelweiss AMC – will be open from July 14-17, 2020. If you are new to Bharat Bonds and want to know what they are, we have written a detailed article on this new debt asset class here.

The latest tranche has 2 options – one maturing in April 2025 with an indicative yield (as on July 8) of 5.49% and the other maturing in April 2031 with an indicative yield of 6.65% (as of July 7). The odd maturity period, short of 5 years and 11 years is to allow you to enjoy capital gains indexation benefit of 6 and 12 years as soon as the financial year kicks in.

The above offer is available as a fund-of-fund (FoF) for those who do not have a demat account. You can get more details about the NFO here.

Before we get into the suitability of this ETF/FoF, let’s get some basic questions answered.

Basic FAQs on Bharat Bond ETF

Will my returns in Bharat Bond ETF be fixed?

Bharat Bond ETF has a fixed maturity and not fixed returns. The indicative yield is roughly the return you can expect if you hold them to maturity. The same will be subject to some minor deviation as the trading (demand/supply) on the individual papers in the ETF can cause some price quirks resulting in yield varying a bit.

Can I buy the ETF or FoF later?

Yes, the ETF will be traded in the stock exchanges (the last issue is trading with healthy volumes) and the FoF will continue to be available with the AMC. But what you need to know is that your return could vary depending on when you invest. It will depend on the interest rate movement. For example, if rates fall further when you invest, the price would have moved up and you will be buying at a higher price. That means your yield on the ETF will be lower. The reverse is also true. If rate moves up and you buy the ETF, you will be buying at a lower price, thus increasing your returns. In short, when you buy later, the current yield to maturity may not be your return. The price at the time of your entry will determine your return.

The PSU bonds held by these ETFs are considered to be high quality. So, will there be no downgrades in the papers they hold?

A PSU bond is not entirely immune to downgrades. However, the index that Bharat ETF bond will track offers some protection. If a bond’s rating goes below AAA (and is still investment grade i.e. above BBB) the index will exclude it in the next quarterly rebalancing. To this extent, your ETF portfolio won’t be stuck with a bad bond. If the bond goes below investment grade then the index will replace it within 5 days of such downgrade. In both these cases, Bharat Bond ETF has to ensure that it makes the needed changes. Of course, given that these are PSUs, the risk remains low. But the ETF is not entirely insulated from a risk of mark down.

Will the ETF buy and hold the bonds till maturity?

No. The same bonds may not remain in the portfolio as the ETF has to rebalance its portfolio in line with that of the index. Besides, whenever fresh eligible issues (adhering to the credit quality, yield and residual maturity of the index) come in, the ETF is allowed to deploy in them. In fact, the ETF need not hold like-to-like papers as the index. There could be times when it is unable to get the same bond as the index due to price or liquidity issues.

This makes the Bharat Bond ETF different from FMPs, which buy and hold the same instruments till maturity. Besides, FMPs are closed-ended while Bharat Bond ETF/FoF can be sold anytime.

Is there ample liquidity for the Bharat Bond ETF?

The last 3 months’ volumes of the presently traded Bharat ETF Bond shows average turnover of Rs 3-4 crore per day, with the longer duration bond (2030) enjoying higher volumes. According to the AMC data, the bid-ask spread has been low at 5-10 basis points, even in the current low liquidity debt scenario. So, you will be able to sell your ETF, whenever you wish, if the liquidity continues.

What is the taxation on these ETFs?

They are taxed like your debt funds. Capital gains less than 3 years is taxed at your slab rate while indexation benefits are available for holding over 3 years and taxation is at 20% after indexation of cost.

Bharat Bond ETFs Vs active debt funds

With just 5 months since the launch of the earlier tranche of bonds, it is early days to comment on the Bharat Bond ETF. However, 2 things have presently worked in its favour:

• Its negligible expense ratio (0.0005% for ETF and 0.05% for the current FoF) wins hands down compared with the average expense ratio of debt funds (0.33% for direct plans of corporate bonds and 0.5% for gilt and constant maturity funds).
• The presently healthy spread (10-year AAA-rated bonds enjoy a 107-basis-point spread and 5-year AAA-rated bonds enjoy a 134 -basis-point spread). Hence, the price rally can be expected to be more pronounced in corporate bond segment.

The data below is based on the rolling 1-month return of the 2 Bharat bonds launched in the end of January 2020.

The above data shows that the Bharat bond ETFs are clocking higher returns, albeit with higher volatility, as can be seen from the standard deviation and the minimum returns. That active funds have some cash and cash equivalents helps reduce downsides better.

The data below, too, is evidence to the fact that in this rate fall period, Bharat ETF has outperformed the nearest peers in its active category. Of course, while a handful of gilt funds and corporate bond funds did beat the respective tenured Bharat Bond ETFs, the later has surged ahead of the category averages.

One important point to keep in mind when you compare the active and passive funds is the maturity profile. For example, we had a lot of investors comparing corporate bond funds with the 2030 maturing Bharat ETF Bond.

Clearly, this comparison is not like-to-like as the data above will tell you that corporate bond category’s average maturity is far lower at 3.28 years.  Hence, the closest comparison for shorter tenure ETFs would be banking & PSU and corporate bond funds and for longer tenure ETFs, it would be gilt and gilt funds.

So, should you invest in the upcoming Bharat Bond ETFs?

Let us look at this from three perspectives. One, an income perspective, two a buy and hold perspective and three from a tactical investment.

• If you are an investor looking for income from this option, you can simply avoid this. This is neither a fixed income option nor will returns come in a linear fashion for you to get some steady profits. Returns will depend on the rate cycle.
• If you are a buy and hold investor – we don’t think the current yields are attractive enough to lock into. Unlike the first tranche where the 2030 maturing ETF had a yield of 7.58%, the present 11-year ETF at 6.65% will not be the best rate to lock into for the next 10 years. You will definitely have better rates in a rate upcycle in future. Also, if you are in the lowest tax bracket (a retiree for example), then options like RBI Taxable Floating rate Bonds can be superior substitutes with regular income flow.
• If you are trying to enter these bonds for a tactical play, then it is true that you might find some price appreciation in the longer duration ETF in the current environment. And as discussed earlier, the healthy spreads allow for superior returns as compression happens. However, what is important for you to know is that if you do not exit and lock the profits, then your returns are likely to normalise. This is easier said than done as booking profits and exiting is not an easy job when you want to wait for the last buck to be delivered! And this is a trait that many retail investors tend to have.

The next question is whether you should prefer the Bharat Bond ETF option over regular active mutual funds. Many of you have asked us questions on this front and we would like to clarify some misconceptions regarding the suitability of the Bharat Bond ETF over mutual funds:

1. Bharat Bond ETFs cannot be substitutes for the shorter duration (less than 2 years) funds that you hold – like liquid or ultra-short. Until these ETFs are close to their maturity, the volatility in them will not allow you to have steady returns like the lower duration funds.
2. Bharat Bond ETFs are doing well now primarily because there is a rate rally – i.e. prices are going up as rate falls. When this trend reverses and rates climb north, these ETFs can even deliver negative returns for some time. At such points, active mutual funds have the leeway to reduce their maturity to focus on accrual, while these passive ETFs would not be able to.
3. Most of you who have written to us about keeping this fund as your only debt holding do not seem to be considering a phase of rate hike. The ETFs are built to gradually reduce their maturity (as they have a fixed maturity) and that means two things. One, their volatility would reduce. Two, their ability to generate high returns like longer tenure gilts will reduce. To tap such opportunities, you would need to again buy longer duration ETFs.
4. Essentially, having a stream of ETFs with varying maturities (called ladder strategy) is one way to tap opportunities and also avoid volatility in the portfolio. This can be done only when we gradually have more debt ETFs with varying maturities available in the market. What many active funds try to build within their portfolio is a ladder strategy and hence the additional fee 😊 With active mutual funds, whether in the case of corporate bond funds or gilt funds, fund managers actively book profits thus adding those gains to your NAV. An ETF is not going to do this for you. It is entirely up to you to book profits if you want to lock into gains. If you simply hold, then you will roughly get the yield at the time of your entry.

To conclude, at this juncture, Bharat Bond ETFs can, at best, be only a supplement to your regular debt holding. And if you decide to hold it, note the following:

• The upcoming longer duration ETF may be more beneficial, only if you are a tactical investor.
•  Do not enter it believing that the current high return scenario will continue. Remember, you need to take charge of when to book profits. Else, you will end with lower returns than you anticipated.
• The ETF consists of high-quality bonds but they are not immune to volatility.
• It is advisable for you to leave some money with actively managed debt funds with lower expense ratio and quality portfolio. Our Prime Funds curates such options.