State Development Loans and what kind of Mutual Funds invest in SDLs

When it comes to debt mutual funds, lot of investors think of the underlying securities as being Government bonds (G-Secs), Corporate bonds (NCDs) or money market instruments (e.g. TPTs, CPs, CDs etc). Different debt and money market instruments have different risk and yield profiles. In more recent years, credit risk has emerged as an important consideration for fixed income investors. In this article, we will discuss about state development loans or SDLs which are gaining attention in the debt market and many debt mutual funds are investing in these instruments. Before deep dive into SDLs, let us understand the economics of how States function in the Indian economy.

Government Borrowing

What is Budget? Budget in the simplest term, is the account of how much the Government earns through tax revenues and other means (e.g. disinvestment, dividends for CPSEs etc) and how much the Government spends on various items e.g. regular Government expenditure on various schemes, capex (e.g. spending on infra projects) etc. If the Government spending is more than what Government earns through tax revenues, disinvestments or other means, then Government will have a fiscal deficit. How will Government meet its fiscal deficit? The Government will have to borrow money from the market and have to pay interest on it. The Government will have to issue bonds; in case of the Central Government these are called G-Secs.

State Government Borrowing

We have a federal structure in India, which in economic terms means that each State will have its own Budget. The State will have revenues / receipts through various taxes like State’s share of GST, Excise Duty, and VAT on certain commodities etc, and other sources (e.g. disinvestments and dividends from State Government PSEs). Like the Central Government, the State will also have its expenses on running the administration, various State welfare schemes, interest expense on State Government borrowings and capex spending by the State. Like the Centre, the State may also have a deficit and will meet its deficit through borrowings. Each State has a borrowing limit.

State Development Loans

The State Governments issue State Development Loans (SDL), which are bonds quite similar to Central Government Bonds or G-Secs. The issuance of these bonds is managed by the Reserve Bank of India (RBI). The investors in SDLs are usually banks, mutual funds, insurance companies, provident funds etc. From a credit risk standpoint, SDLs are considered to be equivalent to G-Secs. The RBI has the power to make payments for SDLs from the Central Government’s budgetary allocation to the States. The SDLs usually have 10 year tenures and make half yearly interest payments.

Why invest in SDLs?

  • Low Risk: As mentioned earlier, SDL’s have quasi sovereign status, in other words, they come with the implicit guarantee of the Government. The maturity proceeds of SDL’s are paid from the amount due to the States from the Central Government. As such, in terms of safety, SDLs are very similar to G-Secs. When compared to AAA rated corporate bonds, SDLs have lesser risk due to sovereign guarantee. This is one of the biggest state development loans advantages.
  • Higher Yields: Market data shows that the yields of SDLs are usually higher than G-Secs. Since the credit quality of G-Secs and SDLs are nearly the same (both enjoy almost risk-free status), higher yields can be an advantage for SDLs. This is another state development loans benefits.
  • High liquidity: SDLs are actively traded and have demand from various institutional investors. This makes SDLs one of the most liquid debt instruments. This is one of the main investment benefits of state development loans.

Which types of mutual funds invest in SDLs?

A large number of debt funds invest in SDLs. These include both passive and active funds:-

  • Passive funds: There a number of fixed income ETFs and index funds / fund of funds (FOFs) investing in CPSEs and SDLs. You need to have Demat and trading account to invest in ETFs. If you do not have Demat and trading account, then you can invest in index funds or fund of funds (FOFs) investing in these ETFs. Consult with your financial advisor if you want to know more about ETFs and index funds / fund of funds investing in SDLs.
  • Active Funds: Shorter duration debt funds may not invest in SDLs as these instruments usually have long durations. Longer duration funds like long term debt funds, dynamic bond funds etc, may invest in SDLs. Corporate bond funds can invest up to 20% of their assets in instruments other than AAA rated corporate bonds; they can also invest in SDLs to ensure high credit quality in their portfolios. Similarly, Banking and PSU debt funds can also invest up to 20% of their assets in instruments other than Banking, PSU and PFI bonds; they can also invest in SDLs. You can check SDL in mutual fund by going through their factsheets.

Who should invest in debt funds investing in SDLs?

  • Investors who want very low / low credit risks.
  • You should check the percentage of state development loans and G-Secs in your scheme’s portfolio.
  • You should have long investment tenures (minimum 3 years) for these funds because they can be volatile in the short term if interest rates change.

You should consult with your financial advisor to know more about debt mutual funds’ investments in state development loans and if they are suitable for your investment needs.

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