Bonds, particularly corporate bonds, trade via a fragmented dealer network, trade reporting occurs with a delay, and many bond-issues rarely trade at all.
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. However, one product which is gaining popularity in the developed world, which has been till now missing in India, is Bond ETFs.
Globally, Bond ETFs have have reported a healthy growth over the last decade. As per the latest data from Bloomberg, the size of Global Bond ETFs now accounts for over $1 trillion AUM out of total $4 trillion AUM across various ETFs. 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 tide over these challenges and can play an important role in increasing retail investor participation in corporate bond market.
What are Bond ETFs
They are passive funds traded on the exchange and invest in bonds just like conventional bond mutual funds. Unlike traditional open-ended bond funds, these funds trade on the exchange throughout the day with a much lower cost compared to actively managed debt funds. Like equity ETFs, Bond ETFs closely track the index allowing investors to buy or sell while investing in fixed income securities.
Bond ETFs have two different structures. One, which tracks specific maturity segments like short, medium and long-term, and second, with specific target maturity. Target maturity Bond ETFs are the latest innovation and could be more suitable in Indian context. While short and medium-term Bond ETFs are like open ended mutual funds, target maturity Bond ETFs are like fixed maturity plans (FMPs). Target maturity Bond ETF has a defined maturity and invests in bonds with similar maturity. This enables it to combine features of bond and mutual funds. These ETFs mature like a bond since they have a specified maturity date. Like individual bonds, investors are exposed to lesser interest rate risk over time as Bond ETF approaches the maturity date.
Distinct advantages of Bond ETFs
Liquidity: Structural issues make trading bonds for retail investors difficult. Bond ETFs provide liquidity in two ways, through exchange and directly through the AMC. On the exchange, AMC ensures that the ETF trades at a price closer to its fair value by appointing market makers. Market makers buy and sell units on the exchange in order to provide liquidity and keep the ETF price closer to their fair value. While most retail investors can transact in ETFs only on the exchange, investors can also transact directly through AMC in multiples of basket size. In such cases the AMC creates or redeem ETF units at prevailing market value a.k.a NAV.
Transparency: Being an ETF, it has transparency of holdings that are disclosed daily unlike Bond mutual funds where the portfolio is disclosed once in a month. Bond ETFs also provide live price which is quoted on exchange following every trade allowing investors to know the fair value of the portfolio during the day.
Bonds, particularly corporate bonds, trade via a fragmented dealer network, trade reporting occurs with a delay, and many bond-issues rarely trade at all. This makes pricing difficult in bonds. Since Bond ETFs are traded on exchange, they overcome these drawbacks and help investors with adequate information for taking informed investment decision
Low cost: Since Bond ETFs follows a passive investing strategy by replicating the index, it has lower costs compared to traditional actively managed bond mutual funds. Globally, Bond ETFs have expense ratio in the range nod from 10 to 20 bps compared to 30 to 50 bps in actively managed bond mutual funds.
The writer is CEO, Edelweiss Mutual Fund. Edelweiss Mutual Fund has been appointed by Government of India to launch India’s first Bond ETF.