Mutual Funds load up on SDLs on higher yields, lower risk

MUMBAI: State development loans --the less popular cousin of central government securities -- are becoming increasingly popular with mutual funds. Higher yields over government securities and corporate bonds, low credit risk and better liquidity are prompting asset managers to load up state development loans in their portfolios over the past two months.

SDLs are currently trading about 110 - 20 basis points (1 bp = 0.01 percentage point) higher than central government securities, at 9.30-9.35%. Corporate bonds are trading at 8.80-8.90%, making it amply clear why fund houses have opted for SDLs over corporate bonds and G-secs.

Schemes like ICICI Pru Gilt Treasury Fund, Kotak Gilt Savings Fund, DWS Gilt Fund, Sundaram MIP, Tata Gilt Mid-term and Birla Sun Life GSF among others have 15-80% exposure to state loans, according to Value Research data. SDLs issued by Gujarat, Karnataka and Tamil Nadu are quite popular among domestic fund houses.

“The yield spread between SDLs and corporate bonds has widened over the past few months. It makes a lot of sense for fund houses to invest in SDLs when triple-A rated corporate bonds are trading at sub-8% yields,” said Lakshmi Iyer, head of fixed income & products, Kotak Mutual Fund. “Compared with some corporate bonds, SDLs are easy to sell in secondary market. But, SDLs are much less liquid than G-secs,” Iyer added.

State development loans are market borrowings by various state governments. Generally, the coupon rates on SDLs are higher than those of government securities of the same maturity. A state with healthy finances can raise funds at rates closer to G-secs; others will have to pay higher yields to raise funds.

RBI acts as merchant banker for these issuances. According to fund managers, SDLs bear much lower credit risk than comparable securities like corporate bonds, non-convertible debentures and debt issuances by state government undertakings. SDLs are considered safer because RBI has the power to make repayments out of central government allocation to states, which lie in an account with RBI.

“Credit risk is near-zero in SDLs. Fund managers are buying SDLs to earn higher yields and reduce portfolio credit risk by lowering exposure to bonds of second-grade companies,” said the fixed income head of a bank-promoted fund house. SDLs are normally sold through an auction process, just like central government securities. These issuances qualify for statutory liquidity ratio (SLR), which financial institutions like banks have to mandatorily maintain.