The Securities and Exchange Board of India (SEBI) issued its draft norms for debt ETFs (exchange traded funds) on 29th November. This set the tone for the introduction of passive debt funds in India. Passive equity funds in the form of index funds and index ETFs are quite popular. What was missing from the palate was the presence of ETFs that are pegged to debt. These norms issued by SEBI will apply to all ETFs that are under process and that will be issued in the future. However, any ETFs based on government securities or treasury bills will not be covered by this circular.
Debt ETF recommendations
SEBI has made some important changes to clarify the position of debt ETFs in the Indian context. To begin with, each debt ETF created must have a minimum of 8 issuers. To reduce concentration risk, no issuer can have a presence of more than 15% in a single ETF. Each ETF must be a combination of bonds with similar ratings and similar duration profile, with little variation. ETFs can also buy bonds that are outside the index but in such cases they have to ensure that the credit rating and the duration profile closely mirrors the existing ETF constituents. Only investment grade debt will be permitted to be included in the ETF portfolio and in case of the bond falling below investing grade, the exit must be within 5 days. Any index that is proposed to be tracked by the ETF must adhere to these regulations.
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Why debt ETFs can add value?
If you take the analogy of equities, the shift to passive funds has been sharp only in the last few quarters. One can attribute that to the CPSE ETFs but the fact is that people are buying passive asset classes in equity. Passive debt acquires importance especially after the spate of defaults that we have seen in bonds issued by corporates. Defaults by Jet, IL&FS, Dewan Housing, and Cox & Kings are all cases in point. By opting to invest in a sound index, this problem of bad bond selection can be obviated altogether. Also, the ETF is a passive approach and hence the costs will be extremely flow. The average equity ETF costs about 0.30%, so debt ETFs should also be extremely economical.
But there are challenges too
For the bond ETFs as a concept to take off in a big way, there are some basic pre-requisites. Firstly, you need to have solid indices well crafted and managed by a team of index experts. That does not exist in equity indices too. Secondly, to adhere to the current SEBI norms, you need a much larger array of bonds so that ETF portfolios of similar ratings and durations can be created and also managed. Lastly, the rating system in India is erratic with drastic downgrades creating its own set of problems. That will also have to be factored. Despite these challenges, the push to debt ETFs is a step in the right direction!