Bharat Bond ETF is an exchange-traded fund with a target maturity date that will invest in bonds of Central public sector enterprises (CPSEs), Central Public Sector Undertakings (CPSUs), Central Public Financial Institutions (CPFIs) and other Government organizations. The NFO offer period is 12-20th Dec 2019. Since it has a mandate to its average portfolio credit rating close to AAA, a relevant question to ask is if Bharat Bond ETF is the solution to credit risk problems in debt funds. Is it worth buying? Are there better alternatives? Let us find out.
Why was the Bharat Bond ETF created? This is a government of India initiative to help public-sector organizations with their borrowing requirements.
Why an ETF? An exchange-traded fund can be freely traded live during market hours and is a low-cost product (Bharat Bond ETF is expected to have a TER of about 0.0005% – source BharatBond.in). This will (1) encourage institutional buyers to participate, insurance companies, pension funds, mutual funds etc. (2) increase trading and liquidity in these bonds.
Although enough dials have been turned to create a buzz in the media, the government or Edelweiss Asset Management that has the mandate to manage this ETF are not counting on retail participants to make it a success. Since ETFs have no commissions, distributors will not recommend them unlike for example Axis Nifty 100 Index Fund (Impressive AUM but is it expensive?)
What is a fixed maturity ETF? This kind of ETF has a designated maturity date. Bharat Bond ETF only comes in two flavours: three years and ten years. The underlying index will also mature at the same time. For example, BHARAT Bond ETF – April 2023 denotes the maturity date.
What is the underlying index? Nifty BHARAT Bond Index which will be initially constructed with AAA bonds. If a bond falls below AAA but is above BBB- (investment grade), the bond will be removed from the index only in the next calendar quarter. Only if becomes junk will the bond be removed from the index in five days.
Therefore it is a myth to assume the portfolio will only hold AAA bonds.
What is the current portfolio of Nifty Bahrat Bond Index?
What is the difference between an open-ended ETF and a fixed maturity ETF? In an open-ended ETF, the fund will keep buying new bonds upon maturity of the existing bonds (or earlier). A fixed maturity ETF will try and hold the bonds up to maturity. For example, a three year Bharat Bond ETF will hold bonds that mature within 12 months of the maturity date. The residual maturity of the 3-Y ETF is 282 years.
What are the advantages of a fixed-maturity ETF? This combines the ability to sell at the exchange at any time (at least theoretically) and eliminates interest rate risk and credit rating change risk if the bonds are held up to maturity and do not default.
Since the portfolio will only consist of bonds in which the government has a stake, the risk of default is the second-lowest after sovereign bonds.
Why was a fixed maturity ETF model chosen? It is possible that the government wanted to give institutions (eg. NPS) an option to eliminate interest rate and credit default risk. This model will also find favour among retail participants who would be more inclined to hold until maturity.
Is the return of principal guaranteed? No. While the underlying risks are comfortably and acceptably low, no such guarantees can be made.
Are returns guaranteed? No, they are not.
Does the Bharat Bond ETF have a side-pocketing option? Yes, it can create segregated portfolios to handle defaults.
What the min and max investment limits for retail investors? These limits apply only during the NFO period. Min: Rs. 1000. Max: Rs. Two lakh.
Are returns predictable? Will I get the indicated yield if I hold until maturity? A little too much is being made out of “predictable returns”. This means nothing. Even if one holds the ETF until maturity, the final returns will be governed by market forces.
For example, the interest received by the fund will be reinvested into the portfolio. The yield of the bonds could be lower at that time (bonds priced higher) resulting in a deviation from the estimated yield on creation. This is known as reinvestment risk. Over three years, this is likely to be minimal but can be significant over a ten year period.
Any changes in the bond portfolio (note that there is no rigid mandate to hold the bonds until maturity), especially a rating downgrade resulting in the need to sell the bonds, will impact yields.
Is AAA rating not the highest form of safety? No. It is a rating based on past data. The repaying ability of a firm can change at any time.
Public sector bonds are the safest, are they not? Relative to a corporate bond, yes. This does not mean default is impossible. FIve years ago how many would have believed a 100% government-controlled company (PSE) like the BSNL would find it difficult to pay staff salaries?
While it is reasonable to bet on no credit trouble over a three year period, anything is possible over a decade.
Do we need a demat account to invest in Bharat Bond ETF? Yes. it is not possible to but these otherwise.
Is this the answer to credit risk problems in debt mutual funds? If you can afford to lock-in your money for three years, then this will minimise (not eliminate) credit risk problems.
With the government keep to reduce its stake in PSUs, portfolio changes and default possibility is much higher over a ten year period. So in this case, the credit risk remains.
What are the risks if I try to sell or buy the ETF before maturity?
The ETF will have to sold or purchased at the prevailing price which could be quite different from the NAV. There will be an intermediary to minimise price-nav deviations, but the real picture will emerge only after the bond lists.
The buyer/seller will be subject to price changes due to supply/demand and credit rating changes.
How is Bharat Bond ETF taxed? Notice that the maturity date of the three-year bond is a little more than three years. This is to ensure the gains (if any) will be classified as long-term capital gains with 20% tax after indexation. This means that the purchase price can be inflated using the cost inflation index before computing the gains.
So effective tax rate would be about 16-18% depending on the rate of inflation. Please note that rate is applicable for all tax slabs. So for those in the 5% slab, a simple FD will work better.
Even for senior citizens, this is not particularly attractive as fixed deposits carry an Rs. 50,000 income tax exemption.
For a sale mid-term, the gains will be added to income and taxed as per slab.
Is it worth investing in the Bharat Bond ETF? The three-year option is certainly better than the ten-year one can be considered.
Are there any better options? A carefully chosen Arbitrage fund (that does not invest in risky bonds) is a better option for those in the 20% and 30% slab. The gains (if any!) has a one lakh tax-free limit and 10% + cess on the rest.
This would make the returns with Bharat Bond ETFs quite comparable without any secondary market risk. That is the arbitrage fund units can be redeemed at any time with no exit load (after one month in some funds) freely.
Is it not a good idea to lock-in to the indicative yield over ten years? No, it is not. Ten years is too long a time to assume one will not need money mid-way. It is a guaranteed way to devalue money due to inflation. The actual yield can depart significantly from the indicated value due to reinvestment risk.
This cannot be used as a part of an investment portfolio as the liquidity is unknown. Rebalancing could be difficult resulting in a deviation in asset allocation. A gilt fund (or even an arbitrage fund) is better suited for this.
Had this been an open-ended index debt fund would it better? Yes. While the credit and interest rate risk would remain, there would no day-to-day difficulty in buying and selling.
Why only three and ten-year options? This is more to help the bond issuer than the buyer. Ideally for retail investors, a one year option and a ten-year option with a three-year maturity profile would have been better. The interest rate and credit risk would be significantly lower.
Summary The three-year Bharat Bond ETF is a reasonable buy for those who already have a demat account. However, for a three-year need, the investment vehicle does not matter much. The ten-tear ETF should be avoided as a forced lock-in does not make sense and the liquidity unknown. Also, note that ten-year bonds would be significantly more volatile.
Investors are better off with fixed deposits, recurring deposits, low credit risk debt mutual funds and arbitrage funds. Let the institutional investors embrace these ETFs. Edelweiss or other AMCs are likely to announce fund of funds based on this ETF. That can be given a miss too.
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