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Posted by: Uma Shashikant / Deepa Vasudevan on Wed, Dec 19th, 2012

State Development Loans

What are State Development Loans (SDLs)?

SDLs are debt securities issued by state governments, to fund their deficits. RBI issues these securities on their behalf, through auctions.  SDLs are eligible securities for SLR and LAF purposes, and are bought by banks, insurance companies, mutual funds, provident funds and other institutional investors.


Why is there a sudden increase in interest in SDLs?

State governments primarily used the amounts they mobilised through small saving schemes (NSSF) and loans from the centre to fund their deficits. SDLs were limited to not over 3.5% of their GDP. But the terms of using the NSSF and central government loans were very favourable, leading to SDLs being the third in importance when it came it state government borrowings.  The 12th Finance commission modified this and based on its recommendations, access to central government loans and NSSF have been reduced, and limits to borrowing using SDLs have been increased to 4% of SGDP.   SDLs have therefore become the largest source of funding for state governments. As of March 2012, outstanding SDLs amounted to Rs.7454 billion, representing about 37% of outstanding liabilities of the states. The proportion of SDLs in state debt is expected to increase in the future as more states opt for market borrowings.


Do all states issue SDLs? 

All 28 states, as well as Puducherry and NCT Delhi are sanctioned SDL limits. Some states issue SDLs regularly, others enter the market rarely. In 2011-12, five states- Uttar Pradesh, Maharashtra, Tamil Nadu, West Bengal and Andhra Pradesh accounted for over 50% of outstanding SDL. In contrast, the seven states of North-east India contributed just 3.5%. Sanctioned SDL limits may not be fully used up in some years. SDL sanctions and issuance rose steeply in 2008-09 as a result of the financial crisis.  In 2011-12, Rs.1484 billion was raised through SDL issues.


How are SDLs structured?

Most SDLs are structured as plain vanilla semi-annual coupon-paying bonds. They are issued for tenure of 10 years only, since 2005-06.  Some of them may have put and call options.


How are SLDs issued?

SDLs are issued by RBI in an auction, similar to the auction of Gsecs. The auctions are yield-based multiple price auctions.  Non-competitive bidding upto 5% is allowed. SDLs are issued as demat securities and are listed soon after issue.  Lack of re-issue impacts liquidity in the secondary markets, as smaller quantities of new securities are issued at every yield-based auction.


How often are SDL issues made?

SDLs are not issued to a calendar, as is the case for central government securities. The amount RBI plans to raise on behalf of the states is indicated on a quarterly basis by RBI, and fortnightly auctions are announced on alternate Tuesdays.  It is however not known as to which State may issue what amounts, until the auction notice is issued by RBI.


Are SDL issues underwritten?

Unlike central government issues, SDL issues are not covered completely by underwriting commitment of primary dealers (PDs). PDs submit their underwriting bids indicating the amount and the fee they need, a day prior to the SDL auction. RBI decides the amount and fee in consultation with the state governments, after examining the bids submitted by PDs.


How secure are SDLs?

The Reserve Bank of India maintains a consolidated sinking fund (CSF) that provides for amortisation of market borrowings of the states, as well as the guarantee redemption fund (GRF), which provides for contingent liabilities arising from the invocation of guarantees issued in respect of borrowings by state level undertakings. This creates an implicit but incorrect assumption that SDLs are guaranteed by the RBI.


How has the spread on SDL over Gsecs behaved?

SDLs are priced at a spread to the yield on a corresponding government security, given the higher credit risk (State governments cannot print notes, for example).  However, the spreads at which SDLs are issued is not reflective of the relative financial health of states. They tend to cluster around 5-7bps difference in spreads, through the finances of state governments show significant qualitative variance. Note the lack of correlation between the fiscal deficit of states and the spreads over central government g-secs (Pic 1).


Pic 1: Fiscal Deficit and SDL Spreads

Fiscal Deficit and SDL Spreads

Source: CCIL, RBI


SDLs are perfect substitutes for each other, for the purpose of SLR, approved securities held in institutional portfolios, or LAF. Institutional investors therefore do not actively seek differential pricing.SDLs have generally traded at 40-50 basis points spread over comparable g-secs. Spreads tend to widen during periods of uncertainty, such as the 2008 global financial crisis (Pic 2).


Who holds SDLs?

Scheduled Commercial banks are the largest holders of SDLs, followed by insurance companies and provident funds. Together they hold about 75% of outstanding SDLs. Mutual funds have an insignificant holding of SDLs. Latest available data for 2010-11 shows that MF holding was only 0.06% of total SDL outstanding at that time.


Are SDLs traded in the secondary market?

Trading of SDLs in the secondary market is very thin. Of the outright trades in g-secs reported by CCIL, SDLs account for 1-3%. These instruments tend to be bought and held till maturity.  A mutual fund holding SDLs should not have a problem selling them to a bank or any other institutional investor, since their holding of SDLs is very small as compared to the market size.


Pic 2: SDL Spread (Jan-06 to Aug-12)

SDL Spread (Jan-06 to Aug-12)

Source: State Development Loans Index - Investibility Issues, ByGolaka C Nath, October 2012.


How are SDLs in a debt fund portfolio valued?

Crisil provides the prices under the gilt valuer, every business day. Gilt valuer prices are not subject to any mark-up or mark down.  Given low training volumes in SDLs, the valuation is based on trade data collected by Crisil, polls with market participants, and adjustments for state-wise clusters maintained by Crisil.


How do banks value SDLs?

Banks value SDLs at a yield that is 25bps more than the yield of the corresponding G-sec, as per Fimmda guidelines. However banks are allowed to trade SDLs in a trading band that is linked to the latest SDL auction cut-off yields.

ravi pk on Fri, Jul 26th, 2013 12:23:11 pm

It was very informative to the extent i could understand for a novice like me. But can somebody explain the concept of 'spread' 'bps'? regrds

satyajit on Fri, Dec 21st, 2012 10:51:24 am

Hi deepa/CIEL/dilip shenoy Read the last para VII.12 the total fund available as insurance is only 473 Bln whereas net SDL borrowings is at 7000Bln. GRF and CSF are just like deposit insurance in case of a default it will take care of requirements on a proportionate basis. Let me reiterate I don't expect the SDL's to default tomorrow, it is just that the spread is there for a reason. The SDL are able to borrow at a lower rate because there is a implicit feeling of guarantee by the central government. Think of 'Spain borrowing' in the euro. It has been able to borrow at base level rates without adequate revenue potential because of the implicit ECB guarantee. and when push comes to shove we all know what happened.

Sanjay doshi on Thu, Dec 20th, 2012 9:39:43 pm

Seems to be a trustee security. Trusts / Section 25 companies may like to invest here if banks can act as market makers.

dilip shenoy on Thu, Dec 20th, 2012 3:19:39 pm

Thank you CIEL. Please eaborate on Satyajit's query.

Deepa Vasudevan on Thu, Dec 20th, 2012 11:39:58 am

SDLs are much less liquid as compared to central govt securities, so if holdings were large, exiting to take advantage of rate movements would be a problem for mutual funds. Ideally, SDLs are best used as a yield-kicker to increase overall portfolio returns especially when interest rates are expected to fall (as is expected in Q1 2013). Second, as our note pointed out, all states do not have the same financial health so credit risk of SDLs is somewhat differentiated. Mutual funds are likely to be aware of inter-state differences, and may plan their exposure according to the risk tolerance of their schemes.

satyajit on Thu, Dec 20th, 2012 9:01:19 am In the link provided RBI implicitly mentions they are equal to G-secs in terms of Sovereign Guarantee. Can you tell me have the RBI mentioned in any term sheet about the sovereign guarantee of SDL's another point; you said CSF & GRF is like a fund that could give us some insurance against default, can you tell us the size of these funds can they cover Rs 7454 Bln. Help us unravel the truth behind SDL's.

Rakesh Goidani on Wed, Dec 19th, 2012 10:13:24 pm

Good one. SDLs are quite a buzz word nowadays. Thanks for this detailed write p

Rajesh kumar singh on Wed, Dec 19th, 2012 9:51:15 pm

At first you all ciel team deserve the greets for such a informative intiative to educate the is very helpful to understand the SDL and it's core advange and impact of any portfolio.I would be thankful if you will give more details why mf has holding in very small stake? why some states are not raised their fund.through SDL likr jharkhand or Bihar?

shirish dantkale on Wed, Dec 19th, 2012 6:30:02 pm

excellent , information new me. thanks

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