The debt market is gaining traction, and under them, State Development loans are gaining popularity as they are offering attractive interest rates to investors with low risk.
But what are State Development Loans? Let’s understand in detail.
As we know that India is a union of several states, and these states have governments which work for the welfare of the people residing there. Similar to any company or central government, the State governments in India also run on a budget.
Their income is generally in the form of state taxes that they impose on the citizens. These states spend primarily on education, health, construction and maintenance of state highways, security and social services programmes etc.
More often than not, the expenditure of the states are higher than their income. To meet the shortfall, the State governments issue State Development Loans, popularly called “SDLs”. SDLs are issued in the form of bonds by the state government to manage their state finances and fund their fiscal deficit.
These bonds generally have a maturity of 10 years with half-yearly interest payments. The ticket size, generally, is in the range of INR 10,000 to INR 10 Lacs.
SDLs are majorly subscribed by entities like bank treasuries, EPFO, Mutual funds, PF trusts, etc. These bonds are subscribed by long-duration debt mutual funds as well. GILT Mutual Funds, which majorly invests in GOIs securities, also invest in these bonds;
Each state is allowed to issue SDLs up to a specific limit.
How to Invest in State Development Loans Bond?
These bond issuances are managed by RBI through auctions conducted on the Reserve Bank of India Core Banking Solution (E-Kuber) system.
Investors can subscribe either through an auction or can purchase in the secondary market.
RBI, in its effort to increase the retail investor’s participation in government securities, allow the Clearing Corporation of India Limited (CCIL) to aggregate the bids received from ‘Retail investor’ in the non-competitive segment of primary auctions of Government Securities and Treasury Bills, the minimum bidding amount is INR 10,000 or in the multiples of INR 10,000.
Brokers like Zerodha also allow the investor to participate in the bidding process through To Coin Platform.
Investors can also invest in these securities indirectly through investing in some of the long-duration debt mutual funds or Gilt Mutual funds.
Now that we have understood what SDLs are and why they are issued let’s understand the advantages of SDLs for common investors.
Benefits of State Development Loans
- Lower Risk: If we compare these bonds with the corporate bonds of an AAA-rated company, say, Reliance, these bonds carry lower risk as they have an implicit sovereign guarantee from the central government. RBI Governor Mr. Shaktikanta Das clarified the Monetary policy meeting held in June 2019 that these instruments are not risky. SDLs are as safe as G-secs because states are considered sub-sovereign. “On the due date of repayment, RBI automatically debits the state government account and makes the repayment. So, there is an implicit sovereign guarantee… they would not and cannot be considered risky,”.
- Please note that although these bond issuances are managed by RBI and RBI also ensures that the SDLs are serviced by monitoring payment of interest and principal, it does not guarantee these bonds.
- Higher Return as compared to Central Government Securities: These bonds carry a little high spread than Gsecs along with the sovereign guarantee. This difference generally is in the range of 25-50 basis points.
Risk Associated with State Development Loans Bonds
Although these bonds carry a sovereign implicit guarantee, they carry certain risks that an investor should be aware of before investing in these bonds:-
Credit risk means the risk of default or delay in repayment by the issuer. Although these bonds carry lower risk due to the implicit sovereign guarantee, the investor should understand the finances of the state government issuing the bonds. Almost all of the state governments are continuously lagging behind their fiscal budget targets and hence some of them may have some difficulty in repayment of these loans. Investors should select those where the fiscal deficit is the lowest. Papers of developed states like Maharashtra, Gujarat, Karnataka and Tamilnadu are more in demand and these states issue SDLs judiciously.
Interest Rate Risk
This is one of the most prominent risks in SDLs, as the credit risk is comparatively lower. Bond Prices and Interest rates are inversely proportional. So if the interest rate in the economy rises, it may impact the yield of the bonds. The investor should understand this relationship and should be cautious about investing in the rising interest rate scenario. To avoid this risk, investors should hold these securities for more than 3 years as the interest rates are volatile in the short term.
The secondary market for government securities is denominated by institutional investors. The ticket size in the secondary market is also high. Also, liquidity is dependent on the state issuing the SDLs. SDLs issued by developed states have high liquidity compared to other states.
Should You Invest in State Development Loans Bonds?
These bonds are a secure investment avenue with an underlying sovereign guarantee. Investors who are risk-averse and prefer capital protection over higher returns can invest in these bonds.
Investment in these instruments is also a good diversification strategy for some investors.
Taxation on State Development Loans
The taxation on the Interest Income of these instruments is similar to any debt instrument. The interest earned on these investments is taxed as per the slab rate for an individual.
The Capital gains on the transfer of these listed instruments are decided on the basis of the holding period at the time of transfer. If the holding period is less than 12 months, then the Short term capital gain tax will be applicable as per the slab rate for individuals. Long-term capital gains tax is applicable at a flat rate of 10% plus applicable cess and surcharge.
State Development Loans (SDLs) carry some risk, primarily interest rate risk, but are generally considered safe investments as they are backed by the government’s implicit guarantee. Investors should carefully evaluate the risks and returns associated with SDLs before investing in them.
Animesh Gupta is a Chartered Accountant by profession and a NISM certified Mutual Fund Expert. He has over 4+ years of experience working in the Financial Services Industry. In his role at Wintwealth, he is part of the Credit and Risk team and evaluates the risk of the bonds available on Wintwealth's platform.