How should you take exposure to State Development Loans

One investment avenue that has opened up for investors in recent years are SDLs or State development loans. These are bonds issued by State governments for raising money. While SDLs have formed part of mutual fund portfolios even in the past, investors got a chance to get a concentrated exposure to them only with the launch of target maturity funds (TMFs). Now, with RBI’s Retail Direct scheme, investors can also directly buy SDLs in auctions conducted by the central bank as per a schedule.

SDLs can offer higher yields than GOI bonds or G-Secs, though they may be less liquid, making an exit before maturity all the more difficult. Concerns on whether SDLs are safe, have however, have been laid to rest after the RBI Governor, in a post monetary policy press conference in June 2019 said that SDLs are backed by an implicit sovereign guarantee and therefore, cannot be considered risky.

Choices on offer

The RBI conducts periodic auctions of SDLs, as it does for G-secs where institutional investors can place competitive bids. Retail investors too can participate in these auctions through a Retail Direct Gilt (RDG) account with the RBI. Five per cent of the borrowing amount is reserved for retail investors under non-competitive bidding. Retail investors can place a bid for the investment amount and are allotted securities at the weighted average rate arrived at in the competitive bidding.

Alternatively, one can take exposure to SDLs through target maturity funds (TMFs) – debt funds that passively track an index with a defined maturity – that have been launched over the past year or so. And there are more to come with many such TMFs currently lined up for SEBI’s approval.

While investing directly in SDLs is an attractive proposition, the TMF route comes with many advantages.

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Here are the key differentiating factors between the two:

Most existing TMFs invest in a combination of SDLs, G-secs and corporate bonds and not SDLs alone. There is though, Nippon India ETF Nifty SDL – 2026 Maturity, an SDL-only ETF, that invests in the constituents of the Nifty SDL Apr 2026 Top 20 Equal Weight Index. Note that, unlike with a TMF that invests in SDLs of several State governments, RBI auctions give you the option of investing in SDLs of specific State governments, if you so want.

Long and short of it

Today, all existing TMFs with some SDL exposure come with a 4-5-year maturity. These TMFs invest largely in SDLs listed on the secondary market and maturing broadly in line with the maturity of the index that they track. On the other hand, if we go by the latest RBI primary market auction held on January 18, most SDLs on sale had a maturity of 10 year or upwards and offered yields of 7.2 to 7.3 per cent. While this looks attractive compared to the 6 per cent (approx.) offered by existing TMFs, these SDLs come with substantially longer tenures.

With interest rates expected to move up, it’s best not to lock in your money in such long-dated papers especially since the lack of adequate trading volumes, may make a premature exit from your investment difficult. Moreover, even if you can exit before maturity, you face the risk of capital loss – fall in existing bond prices as interest rates rise. The longer the maturity of a bond, the higher is this risk.

Ease of exit

TMFs offer a certain degree of return predictability for those who remain invested until the fund matures. While making a premature exit from a TMF can expose you to possible capital loss, you can do so, if needed, with ease. This is at least so with target maturity index funds where you redeem directly with the AMC. In case of target maturity ETFs, which trade on the exchange like shares, this depends on the availability of adequate trading volumes.

Similarly, while buying SDLs in the primary auctions may be easy, despite access to the secondary market through the ‘NDS-OM Secondary Market’ platform that the RBI RDG account provides, selling them may not be easy.

Expenses and taxation

Investing in SDLs through the RBI RDG account entails no cost – neither for opening the account nor for transacting through it. For investing in TMFs, on the other hand, you must bear the expense ratio. Most TMFs that hold SDLs in their portfolio charge 0.15 per cent as expense ratio.

When it comes to taxation, TMFs clearly score over directly investing in SDLs, particularly for those in the higher income tax brackets. Your interest income from SDLs gets taxed at your relevant tax slab rate. On the other hand, capital gains on sale of TMFs (which are debt funds) that have been held for over 3 years get taxed at a flat 20 per cent with indexation benefit. That is, you can adjust the initial investment value for inflation, thereby, lowering your capital gains for taxation purposes. This can bring down your tax liability substantially. 

That apart, TMFs come with lower minimum investment requirements such as ₹500 to ₹5,000 and in multiples of ₹1. Investing in SDLs directly can be done only for a minimum of ₹10,000 and in multiples of it.

High on safety

SDLs are backed by an implicit sovereign guarantee, and therefore, cannot be considered risky