What are State Guaranteed Bonds?
State Guaranteed bonds (SGBs) are the debt securities issued by the State government owned enterprises (SOE) and explicitly guaranteed by the state government.
In this article, we will understand about the SGBs, the risk associated with these instrument and its suitability for the retail investors as an investment option.
But first, lets understand about the State owned companies.
State-owned companies are constitutional bodies formed by the central or State government to participate in commercial activities. These enterprises operate in different sectors of the economy, including power, mining, transport, housing, and the financial sector.
These companies may entirely or partially owned by the state governments. Most of these companies operate in an industry where the sources are abundant or where public welfare can be done. Examples include oil companies, electricity generation and distribution companies (DISCOM), public transportation etc.
The State Owned Enterprises (SOEs) need funds to carry out their operations. While most of the funds required are provided by the state governments, some of the SOEs like Electricity distribution companies (DISCOM), state public transport companies etc need additional funds due to the capital intensive business. Since these companies work for the public welfare, they are in huge losses as they provide their goods and services below cost. To carry out their operations or to fund a specific project, they can issue bonds.
These companies on a standalone basis may not be able to repay their obligations on time, and, to help these companies, the respective state government can guarantee the bonds issued by the SOEs. With the guarantee embedded in the debt instrument, these bonds become investment worthy debt instrument.
Key Features of State Guaranteed Bonds
- These bonds do have the explicit guarantee by the State government. You can find the details related to the guarantee in the information memorandum.
- In addition to the guarantee, most of these bonds have structured repayment mechanism which ensures that the repayment obligation should be met on time. For example, there could be a covenant in the transaction documents that the issuer (SOE) has to maintain at least 2 quarter of the repayment obligations in advance in a separate bank account. This bank account is monitored by the debenture trustee which act in the interest of the bondholders. This structure ensures that the issuer make the arrangement of the funds well before the due date of repayment.
- The Standalone rating of the issuer of these bonds issued by the rating agencies might be below investment grade. However, the rating of the bonds of the issuer, combined with the guarantee by the state government may have a investment grade rating.
Some of the Issuer of the State Guaranteed Bonds
|Meghalaya Energy Corporation Limited*
|The Governement of Meghalaya
|UP Power Corporation Limited*
|The Government of Uttar Pradesh
|Andhra Pradesh Capital Region Developmental Authority
|The Government of Andhra Pradesh
|Andhra Pradesh Power Finance Corporation Limited
|The Government of Andhra Pradesh
Key Risks Associated with State Guaranteed Bonds and Suitability to the Retail Investor
Like any other instrument, these bonds come with various risks. Some of the key risks an investor should understand are mentioned below:
Interest Rate Risk
Interest rates in the market may fluctuate, which can affect the value of the bond. In case interest rates rise, the value of the bond decreases and vice versa.
Apart from the credit risk, i.e. the risk of default, there is also the liquidity risk with these bonds as these bonds are infrequently traded in the secondary market. So it is always advisable not to park the emergency funds in these bonds.
Another popular investment options State Development Bonds, are safer than State guaranteed bonds or bonds issued by SOEs without state government guarantee since the SDL has an implicit sovereign guarantee. Generally, the fund allotted by the central government to the state government is first utilised for repayment of the SDLs.
To analyse the credit risk, we first must understand the financial health of the State as it is also essential before deciding to invest in these bonds.
E.g., a bond issued and guranteed by the state-owned enterprise (SOE) of a financial healthy state will have less probability of default than the bonds issued by the SOE of a state with weak financial health.
As per the RBI Report on the state finances, the top 5 most indebted states are Punjab, Rajasthan, Kerala, West Bengal and Bihar as measured by the debt to gross state domestic product (GSDP) ratio. The ratio may also increase in future in case of any macroeconomic shock. One should be cautious about investing in the debt securities issued by these states.
Further, if you want to invest in these bonds, you should also understand the structure and terms of repayment. The mere guarantee of the state government might not be enough for the timely repayment of the bonds. To reduce the risk of the state government not honouring the guarantee, and to reduce the risk of default in some of the bond issuances, the company’s cash flows are protected by the escrow mechanism, where the issuer has to maintain some quarters of the repayment in advance in a separate bank account.
Instances of Default in State Guaranteed Bonds
There are instance of delay in interest and principal payment of the State Guaranteed bonds (SGBs) as well. State guaranteed bonds issued by Andhra Pradesh Power Finance Corporation Limited are in default as there are instances of delay in interest and principal repayment on the rated bonds. Timeliness of meeting obligations remains uncertain until there is a final resolution on distribution of assets and liabilities between the states of Andhra Pradesh (AP) and Telangana.
The rating rationale link and news article link has been attached below for reader’s reference:
In the case of Andhra Pradesh Power Finance Corporation, what was observed is that the Debenture Trustee failed to invoke the guarantee of the State Government. So, the recovery is uncertain in these bonds.
Madhya Pradesh, Uttar Pradesh, Bihar, Punjab, and Orissa state PSU bonds also defaulted during 2000-2002.
These bonds, however, have been restructured and subsequently honored, but the likelihood of defaults occurring again should not be ignored, even if the possibility of default is low.
State Guaranteed bonds are not totally risk free investment as compared to Soveriegn Guarantee securities (Gsecs) or State Development Loans (SDLs). To make an informed decision, one should carefully analyse the financial health of the State Owned Enterprise (SOEs) and the State which gurantees the bonds issued by the SOE. One should also understand the escrow mechanism in the repayment structure if that is sufficient to repay the obligations on time.