All you need to know about bond ETFs before their India launch later this year

1. To suffice borrowing needs of CPSEs

2. To increase retail participation

3. To deepen the bond market and increase liquidity

Bond ETFs are passive funds which are traded on the exchange ad invest in bonds just like conventional bond mutual funds. But, unlike their more traditional counterparts, bond ETFs are more liquid, transparent and cheaper.

Bond ETFs generally fall into one of four categories: sovereign, corporate, municipal, and broad market. The most common variety is the sovereign bond ETF which tracks bonds issued by the governments of sovereign nations. There are many further ways to slice and dice these four categories. Some ETFs may screen their securities by credit quality or maturity, while others narrow the field by geographical region or industry.

Globally, bond ETFs largely follow two structures — they either track a specific maturity bucket i.e. — short-, medium- or long-term, like a regular mutual fund, or they track a target maturity much like how an fixed maturity plan or FMP functions — invest in bonds with similar maturity as the product.

Radhika Gupta, CEO of Edelweiss AMC says it is the latter which is the more preferred route in a market like India, given that most Indian investors like the stability of a 'fixed' return.

To understand liquidity of ETFs, let us first understand the market structure.

There are three key participants:

1. AMCs: Developed in India

2. Market makers: Not developed in India

3. Investors: Not developed in India

Trading in bonds has so far been an uphill task for retail investors in India and the prime reason has been a lack of sufficient liquidity. The absence of quality 'market makers' (those who provide liquidity by offering units to buyers in the absence of sellers and vice versa) has meant that liquidity has not been sufficient. While regulators are working to address the issue of liquidity, Edelweiss AMC remains confident that they will manage to appoint a market maker.

Bond ETFs provide easy access to a diversified bond portfolio in a transparent manner. Holdings are disclosed daily, unlike bond mutual funds, where the portfolio is disclosed once a month. Bond ETFs also provide a live price which is quoted on the exchange following every trade, allowing investors to know the fair value.

Since bond ETFs follow a passive investing strategy by following an index, they have lower costs compared to actively managed bond mutual funds. Globally, bond ETFs have an expense ratio in the range of 10-20 basis points versus 30-50 basis points in actively-managed bond mutual funds.

The bond ETF will follow the same taxation as a debt with indexation benefits after three years.

Currently, participation in the bond market is mostly dominated by institutional investors. Retail investors' assets under management (AUM) in debt mutual funds is less than Rs 1 lakh crore compared to a total AUM of over Rs 12 lakh crore across debt mutual funds. It is exactly this mismatch that Edelweiss AMC hopes to erase by bringing quality bonds in small ticket sizes within the reach of the retail investor.

Edelweiss' Gupta adds that the retail category is the target investor of the bond ETF and recommends that a bond ETF should form the core portion of a retail investor's debt portfolio by matching the product duration to future goals.

The AMC has currently proposed 2-3 structures which are currently under Cabinet consideration. Once, the green light is given, the borrowing needs of the participating CPSEs will be gauged to arrive at the corpus. People aware of the matter say the AUM could be upwards of Rs 10,000 crore.

CPSE bonds currently account for more than 50 percent of the bond market paper, and Edelweiss AMC says that it does not foresee any difficulty in sourcing of quality bonds.

Edelweiss AMC hopes to launch the new fund offer or NFO of their bond ETF by the end of this year.