State Development Loans (SDL) are debt issued by state governments to fund their fiscal deficit. States in India like the centre run budgets where expenditure is higher than revenue leading to deficits. The deficit by the states is financed partly (SDL issues funded 71% of fiscal deficit for 2011-12) through market borrowings in the form of SDL. SDL issues are managed by the RBI, which also makes sure that the SDL's are serviced by monitoring escrow accounts for payment of interest and principal.
State governments, twenty eight in all, have been running fiscal deficits ranging from 2.2% of GDP for 2011-12 to 2.9% of GDP for 2009-10. Total outstanding market borrowings of state governments stood at Rs 7.6 lakh crores as of March 2011. State governments has borrowed a total of Rs 98,000 crores as of 15th November 2012 and is expected to borrow another Rs 100,000 crores in the next four and half months. The total market borrowing of state governments for 2012-13 will be the highest on record at around Rs 200,000 crores. State governments market borrowing for 2011-12 was Rs 141,000 crores. State government finances are weakening along with central government finances (government fiscal deficit has been revised upwards to 5.3% of GDP against budget estimates of 5.1% of GDP for 2012-13).
The SDL market is similar to that of the government bond market. SDL's are traded electronically on the NDS-OM (Negotiated Dealing System-Order Matching) and traded in the voice market (NDS). The participants in the SDL market include banks, insurance companies, provident and pension funds, mutual funds and other institutional participants. SDL's qualify as approved SLR (Statutory Liquidity Ratio) security and are also qualify as approved investments for insurance companies, provident and pension funds and trusts. SDL's also qualify for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI.
SDL market liquidity is poor with daily traded volumes less than 5% of government bond traded volumes. SDL's are seen as a buy and hold instruments rather than instruments that are to be traded. Banks, insurance companies and provident funds invest in SDLs for the higher yield they provide over and above government bond yields.
RBI holds SDL auctions once a fortnight. SDL auctions are yield based with every auction seeing a fresh ten year bond being issued (some States are issuing bonds with put/call options with option periods ranging from four to seven years and bonds with maturities of four and five years). Institutions participate in the auctions and bid for the SDL based on spread over the prevailing government bond yield of corresponding maturity. For example if the state of Maharashtra is issuing ten year SDL's in the auction, bidders will bid at yields of 8.85%, which is a spread of 65bps over the benchmark ten year government bond the 8.15% 2022 bond that trades at a yield of 8.20%.
The question is why institutions are bidding for Maharashtra SDL at a spread of 65bps over the ten year government bond? Should the spread be lower or higher? The second question is if for example Maharashtra and Gujarat (Gujarat state finances are much stronger than that of Maharashtra) are issuing ten year SDLs, why the difference in yields is not much. Maharashtra SDL will be priced at 8.85% while Gujarat SDL will be priced at 8.82% in auctions.
The answer to the first question on whether spreads should be lower or higher than 65bps is that market conditions such as interest rate outlook, liquidity and appetite for bonds by institutions determine the spreads. The second question on why states with differing credit risk are priced the same is that the market believes that states will not default on loans due to the supervision by the RBI on SDLs. However RBI does not implicitly guarantee SDLs and states cannot print money to pay debtors.
The RBI factor prevents markets from fully distinguishing between good and bad states and this lack of differentiation encourages states to be more profligate. Many states have seen their finances collapse due to fiscal mismanagement (Maharashtra, Tamilnadu are two good examples). Investors should price SDLs as per their finances.
How does an investor read a mutual fund portfolio that has SDL's in it. The investor should question whether spreads on SDL's are worth it and whether the state is having reasonable good finances. A state that has healthy finances (one will not find many) can trade at lower spreads. Investors should look at credit risk of states even if the market is indifferent.
SDL credit spreads at around 65bps is tight especially for states where finances are poor. Investors are better off with government bonds when interest rates are looking to fall. However select states with healthy finances will not harm the portfolio.