Debt fund managers are increasingly turning to State Development Loans (SDLs), attracted by their higher yields compared to central government bonds and corporate bonds. SDLs, which are issued by state governments to finance fiscal deficits, have become an appealing investment option as they offer better returns in the current market environment.
As of now, the yield spread between the 10-year SDLs and the benchmark 10-year central government bond stands at 38 basis points, which has sparked significant interest from fund houses. Notably, Axis Mutual Fund has introduced state-loan-dedicated funds to tap into this growing market.
According to industry estimates, mutual funds invested approximately Rs 3 lakh crore in SDLs during FY25, marking a 10% increase from FY24. While this is an improvement, it remains below pre-COVID levels, primarily due to a reduction in state borrowings, experts say.
The high spread between SDLs and central government bonds is one of the key factors driving this trend. Additionally, SDLs are often more attractive than corporate bonds, which can be less liquid. “States generally borrow less than the announced amount, which makes SDLs appealing,” said Marzban Irani, Chief Investment Officer for debt at LIC Mutual Fund. “In comparison to corporate bonds, SDLs are quasi-sovereign, adding a layer of security.”
The supply of SDLs in the last quarter of FY25 has further fueled demand. Akhil Mittal, Senior Debt Fund Manager at Tata AMC, pointed out that SDLs offer yields equivalent to corporate bonds while also fulfilling statutory liquid ratio (SLR) requirements. This makes SDLs a preferred option for fund managers balancing both yield and regulatory compliance.
SDLs have also started to outperform ‘AAA’-rated PSU corporate bonds for tenures longer than 10 years. Avnish Jain, Head of Fixed Income at Canara Robeco, highlighted that SDLs, being quasi-sovereign, carry less credit risk than corporate bonds and offer better liquidity. “Even for shorter tenures, SDLs are yielding more than corporate bonds,” he explained, noting that corporate bond yields have been compressed due to reduced supply, particularly from PSUs.
Recent SDL auctions have shown yields of around 7.11% for longer-term bonds, reaching up to 7.23% on an annualized basis. In comparison, AAA-rated PSU bonds for similar durations are yielding slightly less, around 7.10% to 7.16%. These discrepancies in pricing are influenced by factors such as supply dynamics, fund flows, and global interest rate movements.
The continued demand for SDLs can be attributed to their perceived safety, as they are managed by the Reserve Bank of India and are often considered nearly as secure as central government securities. Despite challenges such as rising US Treasury yields and a weakening rupee, institutional investors remain drawn to SDLs for their attractive risk-return profile.
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