Context

Edelweiss AMC recently got the government’s permission to launch India’s first bond ETF (exchange traded fund) which will invest in central public sector undertakings.

About

• Soon, Bond ETFs will be another investment vehicle available to retail investors providing access to bonds of state-run enterprises.
• Bond ETFs are similar to how equity ETFs invest in line with indices covering specific baskets like the Nifty50, Nifty Next 50 and Nifty Quality 30, among others
• While bond ETFs are not new in India, they have not been very popular. At present, only three GSec ETFs are available, all with miniscule assets and poor trading volumes.
• The entry of newer bond ETFs comes at a time when traditional bond funds are only just emerging from a painful period of multiple credit defaults. Investors are wary.
• Bond ETFs claim to be different from traditional bond funds by offering high liquidity, transparency and lower costs.
• The cost angle is the most distinguishing facet of bond ETFs. Being passively managed products, these charge a much lower fee than actively managed bond funds. Sometimes even less than 0.5%.
• In the debt segment, there is not much the fund manager can do to enhance returns. Any strategy that can optimise costs is the need of the hour.
• Globally, Bond ETFs have reported a healthy growth over the last decade. The size of Global Bond ETFs now accounts for over $1 trillion assets under management (AUM) out of total $4 trillion AUM across various ETFs.
• The key objectives of launching Bond ETF are:
• To suffice borrowing needs of CPSEs
• To increase retail participation
• To deepen the bond market and increase liquidity

What are ETFs?

• An exchange-traded fund (ETF) is a marketable security, meaning it has an associated price that allows it to be easily bought and sold.
• ETFs are in many ways similar to mutual funds; however, they are listed on exchanges and ETF shares trade throughout the day just like ordinary stock.
• ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.
• ETFs can contain all types of investments including stocks, commodities, or bonds; some offer domestic holdings only, while others are international.

What are Bond ETFs?

• Bond ETFs are a type of ETF that exclusively invests in bonds. Bond ETFs invest in various fixed-income securities such as corporate bonds, treasuries, municipal, international, high-yield, etc.
• Bond ETFs are passively managed and trade, much like stock ETFs on major stock exchanges. This helps promote market stability by adding liquidity and transparency during times of stress.
• Bond ETFs allow ordinary investors to gain passive exposure to benchmark bond indices in an inexpensive way.
• Investors of bond ETFs are exposed to the risk of interest rate changes.
• Bond ETFs are typically of two types: They either track a specific maturity bucket like short, medium or long term or they track a target maturity where they invest in bonds with similar maturity as the product.
• Target Maturity Bond ETFs: They provide predictable returns like Fixed Maturity Plans (FMPs), if they are held till maturity.

Other type of ETFS

• Market ETFs: Designed to track a particular index like the NIFTY.
• Sector and industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology.
• Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn.
• Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth.
• Foreign market ETFs: Designed to track non-Indian markets, such as US’s Dollar 30 or Dow Jones Industrial Average (DJIA).
• Inverse ETFs: Designed to profit from a decline in the underlying market or index.
• Actively managed ETFs: Designed to outperform an index, unlike most ETFs, which are designed to track an index.
• Exchange-traded notes: In essence, debt securities backed by the creditworthiness of the issuing bank; created to provide access to illiquid markets and have the added benefit of generating virtually no short-term capital gains taxes.
• Alternative investment ETFs: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing.

Benefits

• Lower Costs: An investor who buys an ETF doesn't have to pay an advisory/management fee to the fund manager and taxes are relatively lower in ETFs.
• Lower Holding Costs: As commodity ETFs are widely traded in, there isn't any physical delivery of commodity. The investor is just provided with an ETF certificate, similar to a stock certificate.
• Exposure to debt market: Bond ETFs are a cost-effective way for investors to take debt-market exposure.
• Tax considerations: ETFs tend to be very tax efficient and ideal for holding in taxable accounts. Since ETFs don’t sell shares very often and their portfolio turnover is very low, it is very rare for them to generate a taxable distribution for their shareholders.
• IETFs also have the option of making an “in-kind” distribution to shareholders if they want to sell themselves and want the cash.
• However, if the ETF’s portfolio generates dividend income, this income is taxable.
• Transparency: The entire portfolio held by the bond ETF is disclosed on a daily basis to investors.
• This is unlike conventional bond funds which disclose portfolios at the end of every month.
• Further, since bond ETFs are listed on exchanges, they provide live price updates after every trade.
• Liquid: Being listed on the exchanges, bond ETFs also claim to offer liquidity—ability to buy and sell units instantly—for the investor.
• The liquidity in bond ETFs will depend on how actively market makers buy and sell units on the exchange in bulk.
• This will allow the investor to fetch a purchase or sale price closer to the fair value of the ETF, as indicated by its net asset value (NAV).
• Increasing participation: In India, retail participation in corporate bond market is shallow due to structural challenges like poor accessibility, lack of transparency and awareness. Bond ETFs can address these challenges and can play an important role in increasing retail investor participation in corporate bond market.

Disadvantages

• Several ETFs in India are plagued by crippling illiquidity. In the absence of trading volumes, investors often end up buying or selling at a steep premium, or discount to the prevailing NAV.
• While lower cost enhances the return potential of ETFs, absence of liquidity can effectively wipe out cost benefits. Conventional bond funds do not face these issues.
• If evidence is to go by, the initial liquidity in these products will be low, restricting investor’s ability to move in and out at a desired price.
• If the ETFs are not able to amass a decent corpus size, poor liquidity will continue. C
• Bond ETFs cannot assure return to investors any more than conventional bond funds, except certain categories of bond ETFs such as target maturity bond ETFs which have a defined maturity date.
• Unlike actively managed bond funds, bond ETFs will not be in a position to gain from opportunities emerging from movements in interest rates or credit spreads.

Conclusion

To conclude, ETFs offer both tax efficiency as well as lower transaction and management costs. Bond ETFs combine the best of both bonds and debt funds. Indians invest a substantial portion of their savings in fixed income instruments such as small savings schemes, fixed deposits, bonds and various types of fixed income mutual funds. If liquidity is sufficiently high, bond ETFs may be a good first stop for those looking to move from bank fixed deposits.