All entities administer budgets.
Households live within their budgets. In a firm, the marketing and advertising department will get a budget to fund its activities. Central and state government also operate within their respective budgets.
When governments end up spending (expenditure) more than they earn (revenue), this gap is known as the fiscal deficit. This is where an SDL comes into play.
A State Development Loan, or SDL, is a bond issued by a state government to fund its fiscal deficit. Each state is allowed to issue securities up to a certain limit per year.
If you want this debt instrument in your portfolio, answer these questions before you consider investing.
- Are you looking for safety?
These bonds have no credit risk. The Reserve Bank of India (RBI) facilitates the issue of SDLs in the market and ensures that the SDLs are serviced by monitoring payment of interest and principal. The central bank also has the power to make repayments to SDLs out of the central government allocation to states. Since these are quasi sovereign bonds with an implicit sovereign guarantee, there is no credit risk.
- What do you want this investment to do for you?
These bonds pay interest on a regular basis. Interest is paid at half-yearly intervals; the principal is repaid on the maturity date. If you are looking for a predictable income stream, this is great. But if you are looking for a cumulative investment to grow over time, then this is not the right avenue.
- What do you plan to do with the money you earn?
If you need it for your expenses, then it is a good option. If you are not in need of the cash flow and are looking at it as a growth investment, have you considered where you will invest the proceeds? (Reinvestment risk is the possibility that you will have to reinvest the interest earned at a rate lower than its current rate.)
- Do you understand the concept of yield?
The bonds are issued in the primary market through normal auctions conducted by the RBI. They are then traded in the secondary market over its tenure.
As with any instrument traded, the price will rise or fall. As that happens, the market price of the bond will differ from the Face Value. But since the Coupon Rate (interest rate assured on the principal) is static, and is a percentage of the Face Value, the return will differ. This return is called yield. (Do read
What is Yield?)
The returns are predictable if held till maturity. Today’s yield is your actual yield if you hold it till maturity. If you plan to sell before maturity or accumulate on regular basis, the yield will vary (either up or down). Based on the tenure, volatility is part and parcel of such bonds. Longer the time horizon higher the volatility.
- Have you considered the tax aspect?
This is important. The coupon is taxed as per your income tax slab. However, in the case of debt mutual funds, they are taxed at 20% with indexation (if the holding period is more than 3 years) or as per your tax slab (if the holding period is less than 3 years.
- Have you considered SDL Index Funds?
These are target maturity index fund investing in SDLs.
Target maturity date funds are open-ended debt funds with a fixed tenure. The tenure of the fund could range from three to five years. Being open ended, investors can enter and exit at any time.
Purely for the sake of illustration, let me cite an example. Earlier this year, Axis Mutual Fund launched Axis Crisil SDL 2027 Debt Index Fund, a target maturity scheme with benchmark maturity of May 31, 2027. The fund tracks the Crisil IBX SDL Index – May 2027, and the portfolio is designed to invest predominantly in a portfolio of SDLs maturing between December 1, 2026 and May 31, 2027.
Such funds follow a buy-and-hold strategy. The yield offered by these bonds could be higher than the central government benchmark yield. SDL of states which are in better health financially tend to have a lower spread. You can get an indication of the return of the fund (if held till maturity) through the yield to maturity (YTM) of the fund.
Since the portfolio is passively managed, the Total Expense Ratio (TER) of these funds are comparatively lower than actively managed strategies. The regular plan version could have an expense ratio of 0.30% while the direct plan version could charge 0.15%.
As far as taxation goes, it will be the same as debt funds and has been mentioned above.