Introduction To Bond ETFs – An investment option superior to traditional investment avenues

Dear Investors and Advisors,

“How much money can you lose in the stock market?”The month has been full of action in both the equity and debt markets, and while I have frequently used this factsheet to talk about current markets, sometimes it is important to step aside, and look forward. As India's capital markets develop, new opportunities and investment classes will emerge, and it's important to start understanding them. Over the last 9 months, one of the asset classes I have spent a lot of time on is ETFs.

How do bond ETFs work

Now Debt Mutual Funds are a concept investors today are familiar with – whether they invest or not, but Bond ETFs are absolutely new. What does a Bond ETF do? Bond ETFs, as the name suggest, are passive funds which are traded on the exchange and invest in bonds just like conventional Bond Mutual Funds. Unlike traditional open-ended Bond Mutual Funds, these funds trade on the exchange throughout the day with a much lower cost compared to actively managed funds. Like equity ETFs, these Bond ETFs closely track the index allowing investors to buy or sell while investing in fixed income securities. Most Bond ETFs seek to track indexes that follow specific segments of the bond market, such as government, corporate and PSU Bonds. Bond ETFs also seek to track specific maturity buckets, whether they are short term, medium term, or long term. You can also have Bond ETFs with defined maturity such as 3 years, 5 years, and 10 years, referred to as Target Maturity Bond ETFs. They are similar to Fixed Maturity Plans (FMPs) which investors are already familiar with, but carry the additional benefit of liquidity and low cost.

Form an investor's point of view, these three products, Bonds, Bond Mutual Funds, and Bond ETFs may look similar, but all three have distinct features. Bond ETFs specifically have 3 advantages that are important to investors – liquidity, transparency, and low costs.

Liquidity:

Structural issues in Indian bond markets have made trading Bonds for retail investors difficult, and while regulators are working to address these issues, it will be some time before retail investors can trade Bonds easily on a screen. Bond ETFs can tide over these issues and facilitate low-cost bond exposure without the structural challenges like price transparency and liquidity. Bond ETFs provide liquidity in two ways, through exchange and directly through the AMC. On the exchange, the AMC ensures that the ETF trades at a price closer to its fair value by appointing Market Makers who facilitate trades. 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 a pre-defined basket size. In such cases the AMC creates or redeem ETF units at prevailing market value or the live NAV.

Transparency:

Bond ETFs provide easy access to a diversified bond portfolio in a much more transparent way than Bond Mutual Funds. Being an ETF, there is 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 prices which are quoted on exchange following every trade allowing investors to know the fair value of the portfolio during the day. Note that in India the bond market is relatively opaque. Bond trading, 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 the exchange, they overcome these drawbacks and help investors with adequate information for taking informed investment decisions.

Low Cost:

Since Bond ETFs follow a passive investing strategy by following an index, they have lower costs compared to traditional actively managed Bond Mutual Funds. Globally, Bond ETFs have expense ratios in the range of 10 to 20 bps compared to 30 to 50 bps in actively managed Bond Mutual Funds.

To conclude, Bond ETFs combine best of both, Bonds and Bond Mutual Funds. They comprise the same underlying bonds, but exchange tradability feature makes Bond ETFs different in many positive ways. Diversification, ease of trading, higher liquidity and price transparency are the basic advantages of Bond ETFs over traditional bond investments. All this in addition to lower cost makes Bond ETFs an investing option which is superior to traditional investment avenues.

Edelweiss AMC is proud to be partnering with the Government of India in launching India's first big Bond ETF, and we are looking forward to share more information on this asset class as the space and plans evolve. We do believe this is an exciting space both for India's bond markets and for our investors and advisors.

Thank you as always for your support and faith in us, and happy investing.

Regards,
Radhika