Bond Exchange Traded Funds: Good option for fixed income investors
November 6, 2020 12:15 AM
Bond ETFs carry minimal risks, offer liquidity and tax efficiency to the investor while expense ratio is next-to-nil
Being defined maturity products, you can invest as per your cash flow.
By Joydeep Sen
Fixed income oriented investors are faced with certain issues nowadays. Interest rates on bank fixed deposits have come down significantly; the rate on SBI 1-year deposit is 4.9%. There are concerns on safety about banks offering higher deposit rates, as we saw in the case of a few co-operative banks and one private sector bank.
After the multiple defaults and economic slowdown scare, investors prefer safety of their debt investments. While there are certain schemes for senior citizens or other avenues like RBI Floating Rate Savings Bonds that are safe and offer attractive returns, liquidity is an issue. In this background, the concept of debt ETFs is a good option.
Defined maturity Being defined maturity products, you can invest as per your cash flow. The products are target-maturity funds. There is a defined maturity date and in that sense it behaves like a fixed maturity plan (FMP). The implication is, on maturity, there is no market risk as all the securities in the portfolio mature by that date.
The portfolio of these ETFs comprise AAA rated PSU bonds, which are perceived as next to sovereign securities, or a combination of AAA rated PSU bonds and State Development Loans (SDLs), i.e., securities issued by states, which are quasi-sovereign. ETFs are operationally similar to trading in equity shares and there is no purchase from / redemption with the AMC in the regular course. Only in case of very large transactions the AMC steps in for “creation of units” when there is incremental demand from large investors.
Advantages The advantages of the bond ETFs are many. First, credit risk is minimal, next to nil, as investments are in AAA rated PSU bonds or combination of AAA rated PSU bonds and SDLs. Two, interest rate risk or volatility risk is not there, if it is held to maturity. Three, tax efficiency is a significant advantage. For a holding period of three years or more, like any other open-ended debt fund or FMP, debt ETFs are eligible for indexation. The net capital gains after the indexed-up purchase cost is subject to tax at 20%. Effectively, by virtue of indexation, the tax rate becomes negligible. Indexation is a benefit given by the government for inflation since part of the price appreciation from purchase to sales/redemption is due to inflation. The differential between sale/redemption price and indexed-up purchase price is subject to tax at 20%. You need not hold till maturity for indexation benefit, it has to be held for three years or more.
Fourth, liquidity is available in bond ETFs. In open-ended mutual funds, liquidity is easily available. In FMPs, though they are listed at the Exchange, liquidity is absent. In bond ETFs, liquidity is generated by market makers appointed by the AMC.
Fifth, the expense ratio charged by the AMCs to these funds is next-to-nil. The product is meant for the investor; the AMC or the intermediary does not make any money.
Conclusion All you need to invest in bond ETFs is a demat account and trading account with a broker or mobile-based trading app. The operational aspect, i.e., purchase / redemption is with you and is not with the AMC or through a mutual fund distributor. The portfolio and other details like maturity date can be checked on the website of the AMC running the product. Buy into the maturity that suits your cash flow.
The writer is a corporate trainer (debt markets) and an author