Indexing is fast catching up in the financial world as an investment strategy. While indexing is well known for equity investing, does it work in the bond market too? Let’s see.
Why indexing?
Before we get into indexing as a strategy for fixed income investments, let’s look at the broader passive or index investing argument. Index investing or passive investing involves buying an index of securities or a representative basket of securities that represents the broad market and be content with the returns it offers. Thus, the index investor believes that the markets are efficient and that it is impossible to beat the market. Investors who subscribe to this theory prefer passive investing. This approach also brings down the cost of investing- little effort goes into selecting securities and there is also relatively little churn compared to an actively managed portfolio. There is no fear of underperforming the broad market as the investor is invested in the broad market. The fund manager’s role is to mimic the underlying index and keep costs as low as possible. This ensures that the investor takes home market returns though it is important to note that expenses, tracking error and taxes will continue to affect these returns. Tracking error captures how consistently the index fund manager managed to mimic the underlying index, so the smaller this error, the better.
Indexing in bonds
Many investors are aware of index funds in equity markets. There are many open-ended index funds and Exchange Traded Funds (ETFs) that track popular indices such as Nifty-50 index and Nifty Next 50 index. Such equity funds are becoming larger as more investors, especially institutional investors, such as the Employees’ Provident Fund Organisation (EPFO) prefer to invest in them and in some cases, they are mandated to take part or all of their equity exposure through these funds.
To provide an easy avenue for bond index investing, a few mutual funds have launched schemes that track these indices. Bharat Bond ETF 2023 was the first such close-ended, exchange-traded mutual fund scheme that tracked the Bharat Bond Index 2023. This index measures the performance of a portfolio comprising AAA rated bonds issued by Central Public Sector Enterprises (CPSE) maturing in CY2023. There are other bond indices in Bharat Bond Index Series which invest in bonds that mature as late as CY2033. The fund manager of the scheme mimics the index by purchasing the bonds in the same ratio as they are present in the underlying index. The bonds purchased are held till maturity and the coupon payments received from these bonds are used to buy more of these bonds in the same proportion as they are in the underlying index.
The Bharat Bond Index, 2023 scheme recently matured and investors got their money back. Investors were also offered the option to merge into another Bharat Bond ETF scheme.
This is not the only scheme where the fund manager mimics the index. Success of the Bharat Bond ETF series of debt mutual schemes appears to have sparked the growing popularity of another category – Target Maturity Funds (TMFs). TMFs have been investing in various indices comprising bonds issued by CPSE, state development loans (SDL) and government securities (G-sec). The underlying index would have all the bonds that mature around a particular date in the future and the scheme mimicking that index would have a similar maturity. These schemes have little fund manager risk as the fund manager’s role is restricted to mimicking the index. The expense ratios of these schemes are lower than that charged by other actively-managed open-ended debt schemes.
Clear path for investors
Clarity on expected returns offered by these schemes attracts investors. Since the bonds were held to maturity, an investor willing to remain invested till the maturity of the scheme would take home the ‘yield to maturity’ of the portfolio after adjusting for expenses.
Tracking the best
So far, TMFs have been tracking indices made up of bonds with either a sovereign rating or AAA ratings. These bonds are perceived as safe and offer relatively low yields. Though TMFs offer visibility of returns for ‘hold to maturity’ investors, they may need to look for higher yields to beat inflation as the tax rates go up.
Are there shortcomings?
Though the idea of predictable return with little credit risk appeals to many, there are risks arising out of the illiquidity of the underlying securities. Government bonds and AAA rated bonds issued by CPSE are fairly liquid. However, there is no assurance that the fund manager would get to purchase (or sell) them at a fair price at short notice. The scheme’s mandates are such that the coupons or fresh inflows received need to be quickly deployed in the underlying bonds to minimize the tracking error.
Till recently, debt funds were a tax-efficient means to invest in fixed income. Capital gains held for more than three years were taxed at the rate of 20% after indexation. However, capital gains booked on units acquired after April 1, 2023 will not be eligible for indexation benefit and such gains will be taxed at the slab rate. This makes debt funds including target maturity funds less attractive for investors.
Direct bond route
Indexing in fixed income
will remain the vogue. However, investors are now expected to build a
supplementary direct bond portfolio to their passively managed (indexed or TMF)
portfolio, especially owing to the recent changes in taxation. More investors
may look for opportunities in bonds with ratings of AA and below, where both
TMF and other open-ended mutual funds do not invest. This is where the excess
returns in Indian fixed income space may be available over the medium term, as
the risk premium adjusts in line with credit risk involved.
Team AltiFi