Mutual Funds

A lowdown on bond ETFs in India

Radhika Gupta | Updated on October 13, 2019

They are passive funds traded on the exchange and invest in bonds

Corporate bond market in India is still at a nascent stage. Participation is mostly dominated by institutional investors; individual investors’ involvement is dull owing to lower liquidity and limited awareness.

Retail investors’ assets under management (AUM) in debt mutual funds is less than ₹1 lakh crore compared to total AUM of over ₹12 lakh crore across debt mutual funds. Most retail investors prefer bank fixed deposits (FDs) over direct bonds or mutual funds. A key reason for choosing bank FDs could be predictable returns and ease of execution. Bond ETFs (exchange-traded funds) can play an important role in increasing retail investor participation in the corporate bond market. Globally, bond ETFs have witnessed a healthy growth over the past decade.

Bond ETFs are passive funds traded on the exchange and invest in bonds. Unlike traditional open-ended bond funds, they trade on the exchange throughout the day at a much lower cost, compared with actively managed debt funds. Like equity ETFs, bond ETFs also closely track the index and allow investors to buy or sell while investing in fixed income securities.

Bond ETF categories

Bond ETFs generally fall into one of these four categories: sovereign, corporate, municipal, and broad market. The most common are sovereign bond ETFs, which track bonds issued by the governments of sovereign nations, and corporate bond ETFs, which track bonds issued by corporations. Municipal bond ETFs track bonds issued by local municipalities and broad market bond ETFs track a blend of the above. Some ETFs screen their securities further by credit quality or maturity, while others narrow the field by geographical region or industry.

There are also two different structures of bond ETFs; those which track specific maturity segments like short term, medium term and long term, and those with specific target maturity. In developed markets, bond ETFs with specific maturity segment were launched first followed by target maturity bond ETFs, which are the latest innovation in the bond ETF space and could be more suitable in the Indian context. While short-term and medium-term bond ETFs are like open-ended mutual funds, target maturity bond ETFs are like fixed maturity plans.

Target maturity bond ETFs

Target maturity bond ETFs have a defined maturity and invest in bonds with similar maturity. This enables them to combine features of both bonds and mutual funds. They mature like bonds because they have a specified maturity date. Like individual bonds, investors here are exposed to a lower interest rate risk over time, as the bond ETF approaches maturity date. The target maturity Bond ETF is designed to provide returns comparable to the YTM (yield to maturity) of the portfolio, at the time of investments. These ETFs are listed on the exchange and traded throughout the day during market hours, unlike the current practice of over-the-counter (OTC) trading in the bond market. Market makers are appointed to not only enhance, but to also provide liquidity when required. They diversify like a fund; target maturity bond ETFs invest in bonds issued by multiple issuers, thus providing diversification benefit.

Bond ETFs can increase participation from individual investors as it allows them to invest smaller amounts, unlike bonds. Since ETFs have a diversified portfolio, they provide liquidity even for illiquid bonds, as they are held collectively along with highly liquid bonds. Additionally, bond ETFs can have a much lower transaction cost when compared to buying individual bonds on the exchange, as each bond may have a different impact cost owing to varying bid-ask spread. The Centre has planned to launch India’s first bond ETF, which will invest in bonds issued by government-owned entities. This may provide investors an additional avenue to participate in and reduce the current dominance of institutional investors in the bond market.

The writer is CEO of Edelweiss Asset Management Limited (EAML)

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Published on October 13, 2019
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