If you are a fixed income investor looking for a safe parking ground for four to five-year money, open end index funds focussing exclusively on State Development Loans (SDLs) now offer a good alternative to traditional options such as corporate bond funds or PSU & Banking funds. With State governments turning big market borrowers to fund their budget deficits, SDLs have seen improvement in both their yields and secondary market liquidity in recent years.

There are three open end index funds that invest in SDLs maturing in 2027, which you can consider today – Aditya Birla Sun Life Nifty SDL 2027 Index Fund, Axis CRISIL SDL 2027 Index Fund and Kotak Nifty SDL 2027 Top 12 Equal Weight Index Fund.

Why SDL funds

SDL index funds make for sound investment options today for four reasons.

One, SDLs are treated as sovereign instruments for all practical purposes and are therefore among the safest options available in the bond market. SDL auctions are managed by RBI, the same as Central government securities. Interest and final maturity payments on SDLs are serviced by RBI through a special account that States maintain with it, ensuring timely payments and no defaults. Funds that invest exclusively in SDLs therefore carry negligible credit risks, even compared to funds investing in AAA corporate bonds. The SDL market in India has been seeing improving liquidity with a growing pool of outstanding SDLs, as government projects and finances increasingly get decentralised.

Two, despite being sovereign instruments, they offer good spreads over central g-secs of comparable maturity. While historical spreads between SDLs and g-secs were at sub-50 basis points, the spread has widened to 50-80 basis points in recent times. By end-February 2022, 5-year SDLs offered yields of about 6.7 per cent against the 5-year central g-sec yield of 5.9 per cent and 10-year SDLs offered 7.2 per cent against 6.7 per cent on the 10-year g-sec. Markets are also beginning to distinguish between different States based on their financials, allowing investors to benefit from higher yields.

State governments have been raising their quantum of borrowings during and after Covid, triggering a rise in SDL yields. While RBI has actively intervened in the central g-sec market to rein in yields, the SDL market is relatively free of such interventions. The average yield on the CCIL SDL index (duration 7.1 years) has risen from about 6.7 per cent in end-March 2021 to 7.12 per cent by March 2022. Recent tranches of 10-year SDLs from large States such as Maharashtra and Tamil Nadu offered yields of close to 7.2 per cent.

Three, by investing only in SDLs maturing in a specific year and steadily bringing down the average duration of their portfolios as the target date approaches, these funds reduce interest rate risks arising from owning medium to long-term bonds.

Four, though investors today have the option to invest directly in SDLs through the RBI Retail Direct platform, taking the fund route to invest in SDLs makes for better tax efficiency and allows you to own SDLs from multiple States with a limited outlay. When you directly own SDLs, your interest receipts are treated as income and taxed at your slab rate. You are also deprived of compounding benefits on the interest. With mutual funds investing in SDLs, the interest component accumulates and is treated as capital gains. Beyond a holding period of 3 years, you also get indexation benefits on the accumulated returns which significantly lowers your tax outgo.

Fund options

The three SDL funds from Aditya Birla Sun Life, Axis and Kotak have similar target maturity dates falling in April/May 2027, but they track different indices and thus have slightly differing portfolios. The ABSL fund tracks the Nifty SDL April 2027 Index, which has 15 constituents. By end-February 2022, the fund owned Maharashtra, Gujarat, West Bengal, Tamil Nadu and Karnataka as its top SDL exposures, with weights of 8.7-14.7 per cent in its top holdings. The fund carried a portfolio Yield to Maturity (YTM) of 6.47 per cent, an average maturity of 4.93 years and modified duration of just over 4 years.

The Axis fund tracks the CRISIL IBX SDL Index May 2027, which is made up of SDLs issued by 12 States maturing between December 1, 2026, and May 31, 2027. The SDLs are chosen based on the volume and frequency of trading, with a minimum issue size of ₹1000 crore, with rebalancing every quarter. By end February, this fund’s top exposures were over 11 per cent each in Karnataka, Gujarat, TN, UP and Maharashtra. Its portfolio YTM was 6.29 per cent with average maturity of 4.92 years and modified duration of 4.1 years.

The Kotak fund tracks the Nifty SDL 2027 Top 12 Equal Weight Index. The fund has top exposures to SDLs from TN, Karnataka, MP, Rajasthan and Haryana with weights ranging from 7.7 to 10.7 per cent. The fund doesn’t disclose its portfolio YTM.

All funds carry a total expense ratio of 0.3 per cent for their regular plan and 0.15 per cent for the direct plan, making them much cheaper than actively managed corporate bond funds, medium duration funds or PSU & Banking funds.

Advantage SDLs
They offer good spreads over central g-secs of comparable maturity
They reduce interest rate risks arising from owning medium to long-term bonds
Taking the fund route to invest in SDLs makes for better tax efficiency
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