The Bharat Bond ETFs are here and those in the investment ecosystem in India can’t stop talking about them. Asset managers, advisers and the media have all expressed their opinion, which is largely positive and salutary.
The Bharat Bond ETF is, after all, a brand-new investment product; an option that investors didn’t have yet. It’s certainly different; but, does that make it necessarily better? Let’s take a deeper look.
How it compares with other options
The Bharat Bond ETF offers a unique combination of relative return certainty (if held to maturity), beneficial tax treatment (if held for more than three years) and liquidity (if one needs to exit before maturity – as the ETFs will be listed on the exchanges).
Returns from a bond instruments such as debt mutual funds, when held for at least three years, get taxed at a rate of 20 percent, with indexation benefits as well.
Of the three benefits mentioned above, the first two (relative return certainty and beneficial tax treatment) are available on fixed maturity plans (FMPs) that have maturities of more than three years.
The last two factors (tax and liquidity) are available in the growth options of open-ended debt funds, if held for more than 3 years.
Unlike open-ended debt funds, FMPs are listed and are thus, theoretically, liquid. But the complete absence of secondary market volumes means that only the Bharat Bond ETF offers all three features together. These, however, are subject to the ETF fund manager’s assurance that enough liquidity will be offered through a process called as market-making.
With this proposition and indicative yields that compare favourably with bank fixed deposits, there is a distinct possibility that the Bharat Bond ETFs will be successful in collecting a reasonably large amount of money. However, this success will come on the back of significant concerns.
The risk factors
The Bharat Bond ETFs (there is a 2023 maturity plan and a 2030 maturity plan) track the respective indices that contain bonds of 13 AAA-rated central public sector enterprises in the 2023 version and 12 in the 2030 version. Investments in the bonds of each of these companies can be done for up to a maximum of 15 per cent of the corpus.
The rules governing the Bharat Bond Index specify that the index will be tweaked every quarter based on certain parameters. For instance, an issuer will be excluded from the indices if it is downgraded to a rating below “AAA,” or, if it ceases to be a CPSE.
If a company is excluded from the index, the ETF will be obliged to sell its holding of instruments issued by that firm. And this is where the primary concern lies.
Debt ETFs are commonplace in countries that have reasonably vibrant debt markets – those that exhibit a reasonable amount of inherent liquidity. This liquidity is largely absent in the Indian non- government debt market, especially in the longer-term segment in which the Bharat Bond ETFs will operate. In this largely illiquid market, bonds issued by CPSEs are thought to be relatively liquid. But this liquidity isn’t the same for all CPSE issuers and is quite fickle as well, especially when faced with unanticipated changes in either credit quality or the ownership of the issuers.
There is a school of thought that believes the Government of India will ensure these issuers are not downgraded. But the ground realities are different.
Case in point
Let’s take Rural Electrification Corporation (REC) as an example. Bonds issued by REC, which has a 12.72 per cent allocation in the 2030 plan and a 15 per cent allocation in the 2023 plan already trade at yields higher than those issued by say, the Power Finance Corporation (PFC), even though both are rated “AAA” and designated as Navratnas.
An increase in yield means investors are now demanding higher interest rate to lend money to the company – it causes a drop in the price of the bond.
Moreover, bonds issued by REC attract a narrower set of market participants than what PFC does, and are therefore subject to uncertain liquidity. And with good reason.
The government holds 56.16 per cent in PFC. Till recently, the government held 52.63 per cent in REC.
But in March 2019, PFC acquired the government’s entire stake in REC, making REC a subsidiary of PFC. And, even though REC technically continues to be designated as a CPSE, the effective step-down holding of the government in REC currently stands at less than 30 per cent. And this is causing some discomfort to bond-market participants, which manifests in the form of lower participation and higher yield.
The liquidity problem
As things stand, bonds issued by REC continue to have some liquidity by virtue of the company’s rating and ownership. But it is extremely likely that this would vanish if either were to change. This holds true for most of the issuers in the Bharat Bond Indexes and ETFs. And while the indices will find it easy to exclude an issuer, the ETFs will find it most difficult to exit their positions.
Since exclusions and exits will be predictable after a downgrade or divestment, and everyone will be aware of the ETFs’ exact holdings and their need to exit these positions, it is quite likely that such exits, even when available, will happen only at less-than-ideal prices if/when liquidity dries up. This is a cost that will be passed on to the ETF investors.
Moreover, while one may have some element of certainty with respect to the ratings and ownership of these CPSEs over a three-year period, it would take an extremely courageous investor to forecast these out to ten years and risk money on the 2030 ETF.
Given the liquidity realities of the Indian bond market, the Bharat bond ETF may just be an example of putting the cart before the horse. It is a product which promises to offer liquidity even when its underlying asset market does not.
And while, it may achieve some success in raising funds, its potential and its ability to fulfil the assurances to investors will always be undermined by the fact that the bond markets need attention first.(Rajiv Shastri is the former CEO of Essel Mutual Fund and a debt market specialist)