Bond ETFs: Meaning, Benefits, Tax & Things To Consider

Bond ETFs are exchange-traded funds that track the performance of a specific index. Among all the types of ETFs available, bond ETFs are the most beneficial.

Bond ETFs are traded on stock exchanges similar to stocks. Meaning, you can trade them anytime during the market trading hours. These investment options are highly liquid and help to reduce your costs. 

This post breaks down all details about bond ETFs – how they work, benefits of investing in bond ETFs and things to consider before investing. Read on!

How Do Bond ETFs Work?

Bond ETFs are passive funds that investors can trade on the stock exchange. Unlike traditional open-ended debt funds, the units here are bought and sold during the trading hours at a much lower cost.  Investors can easily track the index to make trading decisions. 

In addition, you can also opt for bond ETFs with defined maturity, of three, five or ten years plan. This option is popular as Target Maturity Bond ETFs. It is somewhat like Fixed Maturity Plans which is already common among investors, but come with additional benefits like low cost and liquidity. 

Also Read: Active Funds Vs Passive Funds: Which One Is Right For You?

Benefits of Bond ETFs

• Highly Liquidity 

Retail investors find it challenging to trade bonds because of the structural issue the Indian bond market contains. While several regulators are working to solve the problems, there’s still considerable time left when investors could trade bonds with ease. Bond ETFs has been introduced to cover these issues and bring low-cost bond exposure, excluding structural barriers. 

There are two ways in which it provides liquidity. One is through the exchange, and the other is through the AMC. On the exchange Asset Management Companies or AMC make sure that the trading price of ETFs is closer to the fair value. For this purpose, they appoint Market Makers who control this trade. In other words, they buy and sell the unit on the stock exchange to offer liquidity in trading and maintain the price of the ETF closer to the fair price. 

While retail investors directly trade units on the exchange, they can also transact directly through AMC. However, there is a predetermined basket size in it. When accessing the service, AMC creates and redeems units of ETFs either at live NAV or the existing market value. 

• Low Management Cost

As ETFs come with a passive investment strategy and follow an index, the management cost is comparatively lower. As a result, the expense ratio is lower. Meaning, there are higher chances of getting maximum returns from bond ETFs.  

• Transparency in Portfolio

Bond ETFs enable transparent and easy access to a diversified portfolio thus providing increased transparency. In other words, investors get clarity in holdings when dealing in ETFs as there are daily disclosures.

Apart from this, live prices are listed on the stock exchange following every trade. Thus, investors can know the fair value of their portfolio throughout the trading hours. 

Investors face problems in trading bonds, specifically corporate bonds. As these are bought and sold using a fragmented trade network, there is a high chance of trade reporting delays. Bond ETFs eliminate this problem and help investors get adequate information for correct investment decisions.  

Also Read: 9 Best Monthly Income Plans To Invest In 2022

Taxability of Bond ETFs

Investment in Bond ETFs refers to investing in fixed income securities. So investors will have to follow the taxability structure of debt funds. Here the interest gain can fall under Short Term Capital Gains (STCG) or Long Term Capital Gains (LTCG) depending on the period investors hold the bond. So, profits you gain from Bond ETFs held for less than three years refer to STCG, which is taxable at a marginal rate. 

On the other hand, the interest you gain from debt funds held for more than three years comes under LTCG. It has a tax rate of 20% after considering the indexation benefit. 

Things To Consider Before Investing in Bond ETFs

Every investor must keep a few things in mind to ensure maximised returns from investment in bond ETFs. They include:

• Management of Bond ETF 

Like any other debt fund, Asset Management Companies of AMC launches bond ETFs. So, these are passively managed funds and thus require less administration cost than active ones. 

• Requirement for Investing

To invest in a bond ETF, an investor needs to have a Demat account with a preferred depository participant and a trading account with a sub-broker or a stockbroker. You can also opt for a 3-in-1 account that would include bank, trading and Demat account fused into one.  

• Involvement of Tracking Error

Tracking error means a difference between the return of an ETF and the index it is following. This can happen due to various reasons. The lower the tracking error, the better would be an ETFs performance.  

Final Word

Investors may invest in bond ETFs as a way of diversifying their portfolios. Investing in it can bring in liquidity and cost-efficiency in your investment plan. However, they must go through its advantages, things to consider and taxability structure to make the most out of their investment.

FAQs on Bond ETFs

1. What is the role of Market Makers? 

Market Makers ensure that there is sufficient liquidity available on the exchange of units of ETF. They hold a vast inventory of units and provide liquidity thereby helping to make trading more accessible for an investor.

2.  Can I get assured returns with bond ETF investment? 

No, you won’t get assured returns through an investment in these exchange-traded funds. The value of your investment will vary based on market conditions and interest rate movements.  

3. What does indexation benefit mean?

The concept of indexation reflects the action of inflation on an investment. In other words, under indexation, recalculation of the purchase price takes place by adjusting the inflation rate. High inflations would imply higher purchase price and subsequently lower tax liability. 

4. What is the charge of bond ETF?

They are more cost-effective than actively managed debt funds. This is mainly because these are passive funds since they simply mimic the performance of underlying indices. This reduces the overall cost of management and operations.

5. How to buy a bond ETF?

Buying bond ETFs is quite easy and effortless as they are traded on the stock exchange like any other regular stock. You can trade bond ETF similar to how you buy or sell a stock. However, first, you need to have a Demat account. 

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