How Retail Investors Can Benefit From Rising Interest Rates Of State Government Securities

SYNOPSIS

Apart from the safety aspect, there is a reason to invest in SDLs at this point of time. The yield (interest rate) available on SDLs is on the higher side now, which makes it attractive to invest.

In debt mutual funds, the securities in the portfolio are bonds or other instruments issued by various corporates or banks, NBFCs, and the government. To look at these securities as per the hierarchy in terms of credit quality, top-most are Government Securities (G-Secs), referred to as sovereign securities. State-level securities are similar to G-Secs, just next in the hierarchy and superior to AAA-rated PSUs which are third in the hierarchy. State-level securities are issued by various State governments and are referred to as State Development Loans (SDLs). These are comparable to G-Secs in terms of safety (just a notch lower), though the financial situation varies from State to State. The rationale for safety in central G-Secs is that the sovereign can impose taxes and commands the monetary system.

State governments do not have that authority, apart from levying taxes on a few items like petrol/diesel/alcohol. The safety aspect of SDLs emanates from a different arrangement.

Transfer of taxes collected under GST, from the Central to the State Governments, form the bulk of States’ revenues. These remittances flow through the RBI. All SDLs are serviced by the RBI through two funds called the Consolidated Sinking Fund (CSF) and Guarantee Redemption Fund (GRF) that States maintain with the RBI. Even other than these funds, the RBI can dip into the cash flows from the Central to State Governments, if a State were to reach a state that servicing a

SDL becomes a question mark. There is no instance of any default by an SDL in India, due to this mechanism. To be noted, entities (e.g. companies) owned by a State government, issuing bonds guaranteed by the State government, are different from SDLs. There are instances of delay in those.

Apart from the safety aspect, there is a reason to invest in SDLs at this point of time. The yield (interest rate) available on SDLs is on the higher side now, which makes it attractive to invest. For a perspective on the yield levels, between financial year 2011-12 and 2018-19, the volume-weighted average yield spread (the higher interest rate) for SDLs was approx. 0.45% over comparable maturity G-Secs. Recently, the spread has widened to around 1% for 10-year maturity due to huge increase in supply of SDLs on top of massive increase in supply of G-Secs, as the Central and State Governments are fighting the pandemic-induced slowdown. For another perspective, today home loans are available to individuals at less than 7% and State Governments are taking 10-year loans at more than 7%. This anomaly won’t remain for long; you can benefit from investing in relevant mutual fund schemes at this juncture.

Before we discuss the relevant funds, another aspect: in mutual fund schemes, there is a volatility risk as the daily NAV fluctuates as per the underlying market. This can be addressed by portfolio maturity roll down. In a single bond, if you hold the bond till maturity, there is no volatility risk as the product matures and you get back the redemption proceeds from the issuer. The market risk or volatility risk comes down progressively as the bond nears maturity. In bond funds, this can be achieved either through maturity roll-down open-ended funds or target maturity debt ETFs/index funds. However, if you redeem/sell your holding prior to maturity, your returns would be impacted by the market level at that point of time.

Currently, there are a few offerings in the market which play the theme of superior credit quality portfolio and portfolio maturity roll-down. All the three funds mentioned below are hitting the market with an NFO in March 2021. These are open-ended, i.e., exit route is available as mentioned below.

  • Nippon India ETF Nifty SDL – 2026 Maturity is a target-maturity Exchange-traded Index Fund, maturing in April 2026. It will invest in SDLs maturing within April 2026. The Index i.e. Nifty SDL – 2026 Maturity would use buy and hold strategy wherein the portfolio selected initially would be held till maturity i.e. April 2026. The portfolio will have SDLs of Top 20 States, with equal weightage, maturing between May 2025 to April 2026. ETFs can be bought/sold at the Exchange, for which you need a demat account and an account with a broker, which nowadays can be executed through a mobile app as well. In an ETF, there is no purchase/redemption with the AMC, unless you have a large lot, known as creation unit.

  • Edelweiss Nifty PSU Bond Plus SDL Index Fund 2026 will have a portfolio comprising AAA rated PSU Bonds and State Development Loans, in the ratio of 50:50, i.e., it is not pure SDL oriented. The index, i.e., Nifty PSU Bond Plus SDL 2026 has a maturity date of April 2026. This is not an ETF, hence regular purchase/redemptions shall be with the AMC. In an ETF, regular purchase/sales happen at the Exchange between investors.

  • IDFC Gilt 2027 Index Fund and IDFC Gilt 2028 Index Fund will follow Crisil indices. Portfolio will comprise Government Securities i.e. not SDLs or PSU bonds. The index i.e. CRISIL Gilt 2027 Index will comprise G-Secs maturing between December 2026 to June 2027. CRISIL Gilt 2028 will comprise G-Secs maturing between September 2027 to April 2028. These are not ETFs, hence regular purchase/redemptions shall be with the AMC.

Apart from the funds mentioned above, there are existing index funds/ETFs following a roll-down strategy e.g. Edelweiss Bharat Bond April 2023, April 2025, April 2030 and April 2031, Nippon India ETF Nifty CPSE Bond Plus SDL – 2024 Maturity, etc. G-Secs and SDLs are sovereign grade whereas PSUs are a notch lower. You may match your cash flows with the maturity date of the product. In case you require liquidity, you may sell through the Exchange (ETFs) or redeem with the AMC (index funds). For a holding period of more than 3 years, you get the benefit of indexation for long term capital gains taxation, which reduces the effective tax rate significantly.

However, investors should check the Scheme Information Document (SID) of the relevant mutual fund scheme before investing in order to make sure that the investment strategy advertised by the fund is also incorporated in the SID.

Source: https://economictimes.indiatimes.com/wealth/invest/how-retail-investors-can-benefit-from-rising-interest-rates-of-state-government-securities/articleshow/81648720.cms

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