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Into the world of passive debt investment options

Maulik Madhu BL Research Bureau | Updated on April 10, 2021

Three-in-one: Passive debt funds come at a low cost and have high-quality portfolios. Some offer return predictability too

There were many passive debt fund launches among the slew of new fund offers (NFOs) that hit the market over the past year. The largest among them was Edelweiss MF Bharat Bond ETF NFO (tranche II) which raised close to ₹11,000 crore in July 2020. Others raised another ₹2,400 crore in the following months.

Passive funds, whether in debt or equity, do not actively pick and choose securities to invest in and simply park their money in the securities that constitute the benchmark index they track.

Apart from the attraction of low-expense ratios and high credit quality portfolios, many among these, labelled as target maturity funds (TMFs), also offer return predictability.

Other passively managed debt funds that come without a defined maturity date, too, invest in government debt securities and, therefore, carry no credit risk (failure on part of the borrower to make principal and interest payments). But they are subject to interest-rate risk (fall in the price of existing bonds in a fund portfolio as interest rates rise, resulting in a fall in the fund NAV).

Then, there are liquid exchange-traded funds (ETFs) that passively invest in overnight money market instruments. These funds carry neither credit risk nor interest rate risk.

Here we detail different options in the passive debt fund space and look at factors that investors must consider before parking their money here.

Target maturity funds

A target maturity fund is a debt fund (index fund or ETF) with a defined maturity that passively invests in bonds that constitute its benchmark index. These funds invest in corporate bonds, g-secs (Government of India bonds), SDLs (State government bonds), or a combination of these, and hold them until maturity, earning the coupon (interest) paid by the bond issuers. The interest received is re-invested in similar bonds that too are held till maturity. The fund may, however, sell its bond holdings to meet redemptions, if needed.

Your return from a TMF, whether a newly launched or an existing one, that you hold until maturity will approximately be the yield-to-maturity (YTM) at the time of investing, minus the expense ratio. You can get this information from the fund house website or customer care helpline. If you redeem before maturity, then your return can be higher or lower, depending on how interest rates have moved since you invested. With interest rates expected to move upwards gradually, the possibility of capital loss (fall in the price of existing bonds) with a resultant impact on your fund NAV is high.

What’s on offer: Edelweiss MF’s Bharat Bond ETF 2023 and Bharat Bond ETF 2030 were the first target maturity ETFs launched in India, way back in December 2019. The Bharat Bond ETFs (four series till date) invest in AAA-rated bonds of public sector companies constituting the Nifty Bharat Bond Index and maturing in line with the scheme maturity.

The recently launched Nippon India ETF Nifty CPSE Bond Plus SDL – 2024 Maturity invests a half each in AAA-rated PSU bonds and SDLs that form a part of the Nifty CPSE Bond Plus SDL Sep 2024 50:50 Index.

The IDFC Gilt 2028 Index Fund invests largely in g-secs comprising the CRISIL Gilt 2028 Index. Axis Mutual Fund and SBI Mutual Fund, too, are getting ready to launch their TMFs.

Both g-secs and SDLs enjoy government guarantee, though g-secs score better on liquidity (ease of buying and selling without impact cost), given their large outstanding stock and additional expected supply, thanks to the government’s large borrowing programme. SDLs, on the other hand, can enjoy better yields.

Suitability: Ultra-conservative investors can consider IDFC AMC’s g-sec focused TMFs which are targeting the 6-9 year g-sec segment wherein yields have risen significantly compared to historical levels. While AAA-rated PSU corporate bonds may rank a notch lower than government bonds, the government backing enjoyed by PSUs lends comfort to investors of Bharat Bond ETFs. Here, the 5.66 per cent YTM of Edelweiss MF’s Bharat Bond ETF 2025 looks good compared to other fixed-income options.

These funds, however, make most sense only for those in the 20 per cent and higher tax brackets and can stay invested for over three years. Long-term capital gains on debt funds, that is gain on sale of such funds held for more than three years are taxed at 20 per cent with indexation benefit. This gives them an edge over options such as bank deposits where interest income is taxed at an individual’s income tax slab rate. While making a choice, you must compare the yield-to-maturity of a TMF on the date of investment minus the expense ratio with the yield (accounts for compounding of interest) on a cumulative fixed deposit.

While choosing between funds with similar yields, go for the one where the maturity period is aligned with the time period at the end of which you have a specific financial goal to be met. Money that you may require at short notice, is however, best not parked in TMFs.


Other debt index funds or ETFs

Unlike in TMFs where the scheme matures on a specific date and investor money is returned, in other passively managed debt funds without a defined maturity, investors can continue to remain invested.

Such passive debt funds mostly invest in g-secs that comprise the most actively traded segment of the bond market.

A gilt index fund, or ETF, derives return in the form of interest received on the g-secs held but more importantly from the change in the price of these g-secs. Depending on how interest rates move, g-sec prices can fall (rise), with the resultant capital loss (gain) impacting the fund NAV. When interest rates rise, or are expected to rise, the price of existing g-secs fall as they are in less demand compared to the new higher-yielding g-secs. Factors such as the expected rate of inflation and the quantum of government’s borrowing too impact government bond yields and prices.

What’s on offer: The recent Motilal Oswal 5-year G-Sec ETF and Nippon India ETF 5-year Gilt invest in the Nifty 5 yr Benchmark G-Sec Index, which is essentially a single bond index tracking the most liquid five-year g-sec. The nearly five-year old SBI-ETF 10-year Gilt and Nippon India ETF Long-Term Gilt track the Nifty 10 yr Benchmark G-Sec Index (single bond index) and the Nifty 8-13 yr G-Sec Index, respectively. The latter comprises the top five liquid g-secs with a residual maturity of 8 to 13 years.

Suitability: Passive gilt funds help you mimic the yields earned by government securities over a specific tenure. Five-year gilt funds launched today are designed to take advantage of the steep difference in yields between 1 year and 5 year g-secs. But passive gilt funds are meant for investors who are good at spotting such opportunities timing their entry and exit well.

In an actively managed gilt fund, the fund manager takes active duration calls (i.e., modifies the composition of G-sec holdings of different maturities in the fund) to benefit from the changing rate cycle. But a passively managed fund will simply track its benchmark index, leaving the decision on when to enter and exit to investors.

With interest rates at a low today and expected to go up, the possibility of capital loss makes gilt funds an unattractive option. Unless you can time your entry and exit – enter before rates start to fall and exit before rates rise – in tandem with the changing rate cycle, these funds are best avoided. Alternatively, you must be prepared to stay invested long enough (five years at least) to garner reasonable returns.

A rolling returns analysis over the last ten-year period shows that the gilt fund category (active funds) delivered wide-ranging one-year returns of 19.7 per cent to minus 1.2 per cent (CAGR). The range narrows down to 9.3 to 10.6 per cent (CAGR) with no instances of negative returns once we consider 5-year returns. Similarly, SBI - ETF 10 Year Gilt and Nippon India ETF Long Term Gilt, for instance, have delivered one-year rolling returns in the range of minus 4.7 to 17.2 per cent and minus 3.0 to 19.2 per cent, respectively and three-year rolling returns of 4.4 to 8.7 per cent and 5.3 to 10.3 per cent, respectively, since inception in 2016. Also, with such funds, be prepared to experience short-term volatile returns in the interim.

Liquid ETFs

Liquid ETFs passively park money in the highly liquid overnight money market instruments such as tri-party repo and repo that have a one-day maturity. Liquid ETFs are risk-free as they invest in the overnight market (only for a day) and the transactions (repo) are backed by a collateral of government securities. In tri-party repos, the lender (liquid ETF) has the additional safety of a third-party intermediary such as the Clearing Corporation of India (CCIL).

In terms of the instruments that they invest in, liquid ETFs are like overnight funds and not liquid funds. The latter invest in securities maturing in up to 91 days such as commercial papers, certificates of deposit and treasury bills.

The daily NAV of a liquid ETF is always maintained at Rs. 1000 per unit. As such, any interest earned (treated as dividends) on the money lent by a liquid ETF is re-invested in the ETF in the form of units.

What’s on offer: Nippon India ETF Liquid BeES with an AUM of over ₹ 3,100 crore is the largest liquid ETF. The other two smaller ones are ICICI Prudential Liquid ETF and DSP Liquid ETF.

Suitability: Liquid ETFs are useful for equity market investors looking for a temporary parking ground for their money, where their capital remains intact and also earns a return, as they wait to make short-term stock market trades. When you place a sell order for shares, you can alongside place a buy order for liquid ETFs. Then once the sell order goes through, the proceeds get deployed in a liquid ETF via your trading account, fetching a better return than the balance in a savings bank account would.

Other investors looking to park their short-term surpluses and earn better rates than savings bank accounts can simply use overnight funds. Still better are liquid funds rather than liquid ETFs for such investors. Liquid funds cannot be used to pay for share purchases.

Liquid funds can offer better returns than overnight funds though there is a graded exit load structure for withdrawals up to six days from the day of investment. Overnight funds have no exit load. Most liquid funds and overnight funds (regular plans) have fetched 3 to 3.5 per cent and 2.9 to 3 per cent, respectively, the past year. Nippon India ETF Liquid BeES has made a one-year return of 2.33 per cent (Value Research).

Published on April 10, 2021

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