What are State Development Loans (SDL)? Why are they issued?

There has been an influx of a range of investment avenues entering the Indian market lately. These offer investors an opportunity to explore various risk-return constructs. One such investment avenue that has caught investor attention in recent years is SDLs or State development loans. SDLs are bonds issued by various State governments in the country. Although SDLs have been a part of the mutual fund market in the past, investors now have an opportunity to make the most of a concentrated exposure through target maturity funds (TMFs). Investors can now directly buy SDLs as part of RBI’s Retail Direct scheme.

Here is everything that an investor needs to know about SDLs, including their objectives, who can invest, risk, etc.

What are State Development Loans (SDL’s)?

Like any individual or organization, State governments in the country also have their budgets. At times, the expenditure of state governments may be higher than the revenue in the estimated budget. This can lead to a fiscal deficit. One of the ways of funding such fiscal deficits is through the issuance of State Development Loans (SDL). These are bonds issued by state governments, which allow them to borrow a certain amount while paying interest at half-yearly intervals on them. The principal amount of such loans are repaid on maturity. SDLs generally carry a tenure of ten years.

SDL issues are managed by the RBI. The central bank also ensures that the SDLs are serviced by the state governments by closely monitoring interest and principal repayments.

It is important to note, however, that RBI is not responsible for guaranteeing SDLs. Like any government bond, SDLs can also be electronically traded. Apart from retail investors, SDL participants mostly include various banks, insurance companies, mutual funds, provident funds, and other direct institutional investors. 

Why are SDLs issued?

SDLs mainly help state governments in meeting their budget requirements to cover planned expenditures when revenue collections fall short. These help them in meeting various expenditure requirements by borrowing from the market through bond issuance. The bonds have a fixed tenure and pay coupons or interest for the borrowings.

What are the advantages of SDL investments?

Some of the benefits of investing in SDLs are:

1. Lower risk

As compared to AAA-rated corporate bonds, SDLs carry lower risk due to the sovereign guarantee that comes along. These are therefore considered superior in comparison to corporate bonds. Although the RBI does not guarantee repayment, it has the power to carry out repayments towards SDLs using the central government funds for states. The central bank also maintains a contingent liabilities fund that can be used towards repayment of borrowings by states.

2. Chances of higher returns

The yields on SDLs may, at times, be more than the central government bond yields or benchmark yields. These also offer sufficient liquidity since SDLs can be traded through auctions, just like central government-issued bonds.

Who should invest in SDLs?

Since SDLs are issued by the government, these bonds are highly secure investment avenues with an underlying sovereign guarantee. Investors who are risk-averse and prefer investment security over returns can consider investing in these. These are also suited for investors who have no investment experience in mutual funds. Many investors also use SDL investments to diversify their investment portfolio and balance the overall risk-return profile of their portfolio.

Tax on interest from SDLs

Interest received from SDLs is taxable just like interest income from any debt instrument. Since these generally have a maturity of 10 years, long-term capital gains tax is applicable on the interest income. Long-term capital gains tax is applicable at a flat rate of 20% post indexation plus applicable cess and surcharge.

How to invest in SDLs?

Until recently, only large entities like insurance companies, mutual funds, pension funds, and banks were allowed to invest in SDLs. However, SDLs have now been opened up for retail investments as well. Similar to Gsecs, SDLs are also auctioned by the RBI. Retail investors can invest in SDLs through these auctions. 

SDLs can also be traded by following their prices and yields, as these can keep moving based on factors such as interest rate cycle, new issuances yields, etc. Thus, one can see constant price fluctuations on these bonds. 

Conclusion

As bank fixed deposit rates are going down, investors looking for safer investment avenues are increasingly turning towards alternatives like SDLs. These can act as a good add-on to a debt portfolio with very low risk to capital and better returns than bank FDs. 

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