Is Bharat Bond ETF Risky?

The recent issue of ETFs was oversubscribed and I have been getting many calls from the life insurance sales fraternity on what are ETFs and what are the risks associated with ETFs.

Bharat Bond ETF is India’s first ETF that will invest in public sector corporate bonds – AAA rated.It has garnered Rs.12,400 crores in the public issue, with about 55,000 retail investors. This is by all accounts a good subscription. So what are ETFs?

What are ETFs?

ETFs are similar to mutual funds but with a major difference in how one can sell the ETF after purchase. In a mutual fund, the money is collected and units are allotted. The MF investors can sell their units at the prevailing NAV at the end of the day. Liquidity is certain in a MF since the MF pays the investor.

An ETF on the other hand is like a share. When you purchase ETF you are given a trade-able instrument for the amount you have invested. This instrument can be sold in the stock exchanges at any time during trading hours, not just at the end of the day. You get paid by the buyer of your ETF, not any particular organisation.

Advantages and disadvantages of ETFs

There are advantages and disadvantages for ETFs. The fact that you can sell any time during trading hours is an advantage. But the sale of an ETF is dependent on finding a buyer in the stock exchange. For those ETFs which do not carry sufficient investor interest, it may be difficult to find a buyer instantly. The MF on the other hand is not dependent on finding a buyer, the MF will pay the NAV when demanded. This makes some of the ETFs less liquid.

The Bharat Bond

As far as the Bharat Bond is concerned, the modus operandi they will follow (as given in their prospectus) is that the proceeds collected will be invested for a fixed term in selected AAA rated public sector corporate bonds. The Bharat Bond gives 2 options for the term of the Bond: 3 years and 10 years. How much of the collected money will be invested for 3 years and how much for 10 years will depend on how much has been collected for 3 years horizon and how much for the 10 year term.

Bharat Bond is a Passive Fund

Once invested the money will stay invested in that PSU till maturity. This kind of a fund is called a passive fund, where the fund manager does not sell and buy investments during the term of the bond, like it is done in most mutual funds. A passive fund has lower costs and hence better returns to the investor in the ETF.

In Bharat Bond cash flows can be predicted but are not guaranteed

In Bharat Bond. the rate of interest is known and the maturity value is known at the time of purchase. This is similar therefore to fixed deposits in banks, but not quite the same. Knowing how much interest you will earn till maturity and how much principal you will get back on maturity is not the same thing as a guarantee that you will get the interest and principal. Fixed deposits and ETFs are therefore vastly different from each other in terms of the investment risk they carry.

Investments made in corporate bonds make ETFs risky

A fixed deposit in a bank carries very low investment risk. In the ETF however the risk is higher. The investment risk is similar to any debt fund of ULIP or MFs. The higher investment risk stems from the fact that the investment is made in corporate bonds. Even though it may be public sector and even though they may rated AAA currently, a corporate bond is a corporate bond, and it carries a much higher risk than bank deposits. Investing in corporate bonds is a risky proposition.

Past experience of lending to the corporates

Banks have experienced the risks of lending to the corporate sector in a big way. More than Rs. 11 lakh crore of their lending to the corporate sector has not been repaid by companies. The cases for recovery are in the National Company Law Tribunal (NCLT) for resolution, under the Insolvency and Bankruptcy Code (IBC). And as per latest indications, banks through the IBC route have, in 2018-19, recovered approximately Rs. 70,819 crores, when the loans outstanding on these very accounts were Rs. 166,600 crores. That is to say even where recoveries were made, they could recover only about 42 % of the money those companies owed the banks. The banks have therefore lost 42 % of the amount they had lent to the concerned companies.

Sell Risks Not Returns

Investing in corporate bonds is therefore risky. We must educate our customers on this.