It’s not an easy life for fixed income investors looking to earn decent yields today. With RBI regularly mopping up government securities through its G-SAP programme and also reining in yields on new issues, the 10-year government security has been caught in a range of 5.8 to 6.3 per cent for the last one year, despite elevated inflation.
The extra returns that PSU and AAA-rated corporate bonds used to give over g-secs (known as spreads) have narrowed a lot too. The current spreads of 40-45 basis points are in fact well below historical spreads of 70-80 basis points for AAA rated corporate bonds for 10-year tenures, making this an unattractive time to invest in AAA corporate bonds or funds that play only on them.
The SDL opportunity
In this context, adding State Development Loans or SDLs which represent borrowings by the governments of Indian States, to one’s portfolio offers the opportunity to deliver relatively higher yields, without compromising on safety.
After going on a borrowing binge in FY21 with over Rs 8 lakh crore of loans to finance their Covid related expenditure, Indian States have been moderating their borrowings in FY22. From April-September 14 2021, 25 Indian States and one Union Territory raised Rs 2.83 lakh crore in market borrowings against Rs 3.12 lakh crore in the same period of FY21. But while the supply of State government bonds is lower than last year, it is still elevated compared to historical trends. States have also been relying on the RBI’s special drawing facility and ways and means advances to bridge revenue shortfalls instead of long-term loans. All this SDL supply has led to States borrowing at higher interest rates than usual. The table below shows the cutoff yields at which SDLs were recently auctioned.
Traditionally, State governments have been perceived by bond markets as being safer than top-rated corporates (as they are close to sovereign) and thus have offered lower yields than AAA rated companies. Today though SDL yields are higher than AAA corporates due to elevated State borrowings, a market anomaly that may not last very long. Currently, SDL yields are at a 70-80 basis point premium over 10-year central government bonds and 30-40 basis points over AAA corporate bonds.
Should SDL spreads normalize over the next few months as States moderate borrowings (which will mean falling yields), that can benefit SDL investors as prices could see some gains. The yield differentials make a case for investing in SDLs or State government bonds over AAA corporate bonds or central g-secs right now. But it isn’t really necessary for investors to lock into long-tenure 10 or 15-year SDLs to benefit from the higher yield.
The 5-year sweet spot
Currently, India’s yield curve is the steepest between the 1 and 5-year tenures and somewhat flat at 5 to 10 years. To illustrate, while 1-year treasuries offer yields of about 3.6% today, 5-year g-sec offer 5.4%. In effect, locking into a g-sec for 5 years instead of 1 year gives you 180 basis points in extra yield, but locking into a 10-year instead of 5-year gives you just 60 basis points more.
The shape of the yield curve is quite similar for corporate bonds and SDLs too. Investors on the hunt for fixed income options today therefore stand to maximise their yield by opting for 5-year securities, rather than either 1-3 year bonds or 10 year ones. Data from Aditya Birla Sun Life Mutual Fund shows that 5-year SDLs offered yields of 6.23%, versus 5.92% on AAA-rated PSU bonds and 5.67% on 5 year g-secs.
Directly participating in SDL markets may not be an easy proposition for retail investors for two reasons.
One, participating in primary bids requires the ability to review and analyse State finances which may not be easy. Selecting the right SDLs to invest in, requires analysing numbers such as State borrowings, revised estimates and budget projections of fiscal and revenue deficits, States’ ability to keep within FRBM targets, revenue collection trends, borrowings to GDP et al. Numbers on State finances are not as easily accessible as those on the Central government finances and usually become available with a lag.
Two, SDLs unlike central g-secs tend to be sporadically traded with only a few securities enjoying liquidity. It is thus essential to put SDLs through liquidity filters before making investment choices.
Passive SDL funds
Investors keen to invest in 5-year SDLs may benefit from taking the mutual fund route to investing in a basket of such securities. Today there are debt funds that either invest in SDLs or in a mix of SDLs and PSU bonds available as ETFs or in the open-end format. These funds are usually tailored as passive debt funds tracking a customized index and own securities that mature on a specific target date. You currently have four options to choose from in this category, with different mixes between SDLs and PSU bonds, with target maturity dates around 2026-2027.
#1 Nippon India ETF Nifty SDL 2026 Maturity
This target maturity ETF launched in March 2021 tracks the Nifty SDL Top 20 Equal Weight Index maturing in April 2026, which is invested in the 20 States/UTs with the highest outstanding issuance amount in 2025-26. More details about this fund is available in our NFO coverage. Though the fund started out with equal 5% weights in each SDL, these have subsequently changed owing to price drift. Weights are capped at 15%, in case of price drifts.
The Nippon ETF, which strives to replicate this index had an actual portfolio with a near 10% weight in Bihar 2026 SDLs, 7% in UP 2026 SDL, 5.5% in Chhattisgarh 2026 SDL and so on in August 2021. The portfolio Yield to Maturity (YTM) was 5.92% as of August 31 2021. It had an average maturity of 4.43 years and total expense ratio of 0.15%.
#2 Edelweiss Nifty PSU Bond Plus SDL Index Fund 2026
This is an open end fund launched in March 2021 that tries to mirror the Nifty PSU Bond plus SDL April 2026 50:50 Index, which divides its portfolio equally between AAA-rated PSU bonds and SDLs. The index selects AAA rated PSU bonds with minimum outstanding of Rs 100 crore maturing in line with the target date for its PSU bond portion. The SDL portion is invested in 10 SDLs most recently issued by States March 2021 maturing over 2025-26. While the PSU bond component may weigh on yield at this juncture it does enhance portfolio liquidity.
The fund’s actual portfolio had 37% in SDLs, 25% in PSU bonds, 6% in G-secs and the rest in money market securities by end-August. Its latest average maturity (as of September 21) is 4.39 years, modified duration 3.64 years and Yield to Maturity (YTM) is 5.78%. The total expense ratio of the Direct option is 0.16%.
#3 ICICI Pru Bond Plus SDL 40:60 Fund September 2027
This open end fund is currently in its NFO period (NFO closes on September 27) and has a longer maturity than the above funds at 6 years. It proposes to track the Nifty PSU plus SDL 40:60 index. It will invest 40% of its portfolio in the 8 most liquid AAA-rated PSU bonds maturing in 2027 and 60% in 20 SDLs with the highest outstanding amounts maturing in 2027. While the fund will start with equal weights to all its holdings, subsequent price drift may change weights, but individual issuers will be capped at 15%. The PSU bond component is expected to be invested in NTPC, PowerGrid, IRFC, NPCIL, NHPC. NABARD, PFC and Exim Bank while the SDL components feature all top States. The YTM of this index as of September 8 was at 6.25%. The average maturity is expected to be at about 6 years. The fund’s direct expense ratio is expected at 0.15%.
#4 Aditya Birla Sun Life Nifty SDL Plus PSU Bond Sep. 2026 60:40 Index Fund
This fund is also in its NFO period which is set to close by September 23, 2021. This fund strives to track the Nifty SDL Plus Bond 60:40 index maturing in September 2026. It plans to have a 60% SDL component with 10 bonds and 40% PSU bond component with 11 AAA rated PSU bonds. Both securities will be selected based on a composite liquidity score. To start with it will have 6% weights in each of its SDLs and 4% in each PSU bond though this may drift with time. The current YTM of the index is 5.91%. The expense ratio is unavailable but likely to be in the range of 0.15% for the direct option.
What to weigh
Investing in the above funds gives you access to a diversified portfolio of more liquid SDLs, thus lifting your yield compared to PSU funds and corporate bonds. As all of these funds are passive, expense ratios (on direct options) are more reasonable than most active debt categories at 0.15-0.16%. All these funds offer the benefits of ‘roll-down’ with a definite target maturity date, that helps you match your investment horizon or goals to the maturity of these funds. ‘Roll-down’ means that the fund will follow a largely buy and hold strategy so that its residual maturity will reduce with time as you near your goal. This helps protect your capital from the risk of rising interest rates (which causes capital losses on bonds). Like other bond funds with a more than 3-year tenure, the capital gains on these funds enjoy indexation benefits that help you pay minimal tax on your returns compared to alternatives like bonds or FDs.
On the flip side though, do note that the portfolios of these may not exactly mirror the underlying index at all times owing to inflows or outflows and the non-availability of securities when the fund is in the market to buy. Any variation in the fund’s actual portfolio over time relative to the index can mean variation in the returns you end up with, compared to what is indicated by the current YTM (minus expense ratio). All these funds choose their SDLs based on liquidity factors or the availability of primary offers that mature at a specific time, and NOT based on the finances or fundamentals of each individual State. Though they may start off with equal weights, the portfolio weights can drift quite a bit from the initial allocations due to price changes.
While SDLs presently offer a better deal on risk-reward than corporate bonds or g-secs, the absolute level of yields on SDLs are not at their most attractive at sub-7%. The capital value of a fund’s investments in both SDLs and PSU bonds can suffer setbacks should market interest rates rise sharply from here.
Overall, if you have a lumpsum to invest in 5-year goals, you can consider the above funds ahead of alternatives such as bank deposits or short duration debt funds, as they offer tax-efficiency with more predictable returns.