State Development Loans (SDLs) have, in the last 1­2 years, emerged as an interesting option for debt investors. Attractive returns due to a rise in interest rates is a key reason.

The lowdown

SDLs are issued by the RBI on behalf of State governments. The tenure of the bonds is generally 10 years but the issuer can choose a different tenure. The interest on SDL is paid twice a year and the principal is paid on the date of maturity.

An SDL is considered risk-free. Since it is issued by the State government, it has an implicit sovereign guarantee. In case a situation arises where an SDL may default on the day of maturity, then RBI has the authority to repay the SDL holders and the amount thus paid will be adjusted by the Central government against the amount due to the States from the Centre.

The returns on SDLs are decent. The current yield of CCI SDL index is 7.68 per cent. The yield differs for each State as per the demand and other factors such as liquidity. SDLs generally trade at a premium or spread above Government of India bonds of same tenor; the spread on these bonds depends on State finances. States with better finances have lower spreads. It must be noted that interest earned from SDLs is taxable under the head “income from other sources” at the slab rate.

Since SDLs are issued by State governments and have sovereign backing, these instruments are ideal for risk-averse investors seeking secure returns. These instruments can also be a good option to diversify one’s existing portfolio as they bring down the portfolio’s overall risk.

However, the maturity tenure of these instruments is significant, and these bonds are also vulnerable to interest rate cycles. Therefore, one must factor in these aspects before investing in SDLs.

There are two ways to invest in SDLs — direct investing through RBI Direct platform or through investing in Target Maturity Funds.

RBI Retail Direct

Traditionally, retail participation in G-secs has been indirect i.e., retail investment in government securities has been mainly through institutional routes — for instance, mutual funds. However, to enhance retail participation in government securities directly, RBI has launched RBI Direct platform (https://rbiretaildirect.org.in/#/), which allows retail investors to invest in G-secs. RBI conducts auction of SDLs every Tuesday of the month and investors can sign up on “RBI Retail Direct” platform to place their bid. The auction of these securities is the primary market for g-secs.

RBI facilitates the trading in SDLs through its NDS-OM, which is a screen-based electronic anonymous order matching system. The membership of the system is open to entities that maintain SGL accounts with RBI. However, for retail investors, an internet-based web application of NDS-OM has been set up (https://retail.ndsom.com/). Another platform retail investors can approach is NSE goBID (https://eipo.nseindia.com/eipodc/rest/login), which facilitates investment in G-secs, T-bills, etc.

The minimum investment for subscribing to SDL through direct route is ₹10,000 and the maximum limit allowed for any individual is 1 per cent of notified amount (face value) per auction. In case an investor wishes to opt for any fund to take exposure in SDL, then the limits will be as per the scheme.

Target Maturity Funds

Target Maturity funds (TMFs) are passive funds that track the underlying bond index. TMFs put investors’ money in defined government securities and hold them till maturity. The return for investors in this can be expected to be close to YTM — provided they stay invested for the whole tenure. Apart from pure SDL-based TMFs, those based on a combination of SDLs/G-Secs/PSU Bonds are available too.

TMFs have a defined maturity date and investors receive the total proceeds — which includes the principal invested and accrued interest — on the due date. Target maturity funds can be ETFs or Index funds. TMFs are also liquid, and investors need not wait till the maturity date to receive the proceeds. In case the TMF is an ETF, then the investor can sell the units in stock markets and in case of index funds the units can be redeemed from the fund house itself.  Investments until April 1 enjoy indexation benefits for long-term capital gains tax on redemption of TMFs.