Thread by @avasthiniranjan

A thread to understand all about State Development Loans (SDLs).
Why you should invest now and how?

1. What is an SDL?
They are market borrowing by various States of India in form of bonds. These bonds are auctioned by the RBI on regular basis in the same manner as G-Sec.

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They share similar characteristics such as:

-The coupon rate for each state is decided by the auction process
-The RBI conducts the auction process on behalf of States
-The interest is paid on semi-annual basis with bullet payment on maturity
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- SDLs do not carry any credit risk. As a result, they carry zero risk weight – similar to G-Sec & T-Bills
- SDLs are eligible for SLR investments – similar to G-Sec & T-Bills
- SDLs are eligible for LAF and Repo operations – similar to G-Sec & T-Bills

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2. Why do States issue SDLs?

States issue SDLs to finance the gap between their revenues and expenditures.

In the Indian system, the GOI cash transfers form bulk of States’ annual revenues. However, states’ total expenditure far exceeds their total revenue collection.

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A large portion of this gap is funded by issuing SDLs in the open market in a transparent manner.

In recent times, around 80% of States’ fiscal deficit is being funded through issuance of SDLs.

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3. How do States services SDLs?

All SDLs are serviced by the RBI through the Consolidated Sinking Fund (CSF) and Guarantee Redemption Fund (GRF) that States maintained with the RBI. As a result, there is a high degree of certainty on interest payments and principal payment.

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4. Is there any instance of default in SDL?

There is no instance of any default by an SDL in India.

In that case, why do SDL pay higher interest rate the G-Sec?
This is on account of relative illiquidity.

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Although, SDLs and G-Sec carry similar risk and credit characteristics, one major difference is the number of primary supply of SDLs by various states.

While GOI tends to reissue same bonds multiple number of times until the amount outstanding reach a particular threshold

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States, on the other hand, generally prefer to issue new securities on each auction date.

This causes fragmentation of SDLs in the bond market and prevents consolidation of single SDLs. This contributes to relative illiquidity in the secondary market as compared to G-Sec.

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The table captures the major difference in terms of outstanding number of SDLs and G-Sec in the market as on Jan 31, 2021:

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5. What are different maturity tenors of SDLs?

States generally prefer to issue long-tenor SDLs. Most states prefer to issue 10-year SDL in order to seek favorable yield spread over 10Y G-Sec. However, lately, some States have been issuing SDLs for 2 yr and 25 yrs also.

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6. What has been the average yield spread for SDL over G-Sec?

Between FY12 and FY19, the volume-weighted average yield spread for SDL has been around 45 basis points over comparable maturity G-Sec according to a research paper.

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However, recently, the spread has widened to around 100 basis points over 10-year G-Sec on account of massive increase in the primary supply of SDLs coinciding with the massive increase in the primary supply of G-Sec on account of the pandemic.

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7. What has been the recent trend in SDL issuances?

States play a pivotal role in India’s growth story and nation building.

It has been observed that total annual expenditure by all States put together is similar to the annual total expenditure by the Central Government.

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As a result, primary supply of SDL has been growing at a faster pace than growth in G-Sec.

For example, total issuance of SDL in FY21 is Rs. 7.14 trillion as on March 3, 2021. This is around 31% higher than borrowing of Rs. 5.14 trillion in the same period in FY2020.

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8. Is there any difference between an SDL issued by State A and an SDL issued by State B?

Theoretically speaking – Should be. Practically speaking – Hardly. Since bond market participants are quite comfortable with the present mechanism for SDL involving the RBI.

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As a result, the difference in coupon rate of an identical maturity SDL issued by State A and State B is generally not commensurate with the fiscal strength of State A or State B.

In General, the difference in coupon rate is around 2-5 basis points during the auctions.

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That said, the RBI has been trying to introduce various measures through which bond market will start differentiating SDLs based on fundamental factors of States and price them differently.

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SDLs are currently trading at attractive spreads which makes a good case for investments now.

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One easy way to invest in SDLs is through recently launched @EdelweissMF Nifty PSU Bond Plus SDL Index Fund 2026.

It allows you to invest in SDLs maturing in next 5 years and hold them till maturity.

Details of the fund here edelweissmf.com/edelweiss-nift…

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