Are high-yield state government bonds (SDL) in India safe? Uncover the risks, returns, and what every investor must know before buying these attractive bonds.
The Indian bond market is evolving rapidly, with more investors now exploring beyond the usual fixed deposits and central government securities. One segment that has recently caught the eye of yield-hungry investors is State Government Bonds, also known as State Development Loans (SDLs). These instruments often offer higher yields than comparable central government bonds, making them look like a sweet deal on paper. However, what many investors overlook is the element of risk that comes bundled with these bonds.
While we have long believed that “government” and “safe” go hand-in-hand, it’s time to question that notion—especially when it comes to bonds issued by state governments. This article delves into the intricacies of SDLs, explores their past performance, risk profile, and what investors must keep in mind before diving in.
High-Yield State Government Bonds: Safe Investment or Risky Bet?
What Are State Government Bonds (SDLs)?
State Government Bonds or State Development Loans (SDLs) are debt instruments issued by individual state governments in India to meet their borrowing requirements. Like central government bonds, SDLs are auctioned by the Reserve Bank of India (RBI) on behalf of the states.
These bonds are typically long-term (ranging from 3 to 30 years), pay semi-annual interest, and are considered a step below sovereign securities in terms of safety.
Since states don’t have the power to print money like the central government, their repayment ability is largely dependent on tax revenues, central transfers, and overall fiscal discipline.
The Appeal – High Yields, Government Backing
The number one reason SDLs have become popular among investors—particularly in debt mutual funds and individual high-net-worth portfolios—is the higher yield. In many cases, the Yields to Maturity (YTM) on SDLs exceed those of Central Government Securities (G-Secs) by 30 to 80 basis points (0.30% to 0.80%).
For investors in the current high-interest-rate environment, that additional yield seems tempting, especially when coupled with the perception of government backing.
But herein lies the catch—the “perceived” safety might not align with the actual financial health of the issuing states.
Case Study: Andhra Pradesh and Tamil Nadu
To understand the potential risks of SDLs, let us go back a few years. Around 2019-2020, states like Andhra Pradesh and Tamil Nadu were among the top borrowers in the SDL market. While these states consistently raised funds through bond auctions, there were concerns about their debt sustainability.
Ratings agencies like India Ratings and CRISIL began expressing caution, highlighting rising fiscal deficits and over-reliance on central grants.
In 2020, Andhra Pradesh delayed the repayment of some of its power sector bonds, raising red flags in the investor community. While these were not SDLs, the delay still indicated financial stress in state-run enterprises. Eventually, the bonds were paid back, but not before trust was shaken.
This is a classic example that while the default on SDLs hasn’t happened yet, delays and associated stress signals should not be ignored.
How Safe Are SDLs Really?
As of now, no state government has ever defaulted on an SDL. The RBI acts as the debt manager for the states and has always facilitated timely repayment. However, the RBI does not guarantee SDLs explicitly. This is where the lines blur for investors who assume an implicit sovereign guarantee.
If a state government were to face extreme fiscal stress—such as during a major economic downturn or a political crisis—there could be delays or even restructuring of repayment obligations.
It’s important to understand that the RBI’s role is limited to managing the issuance and repayment schedules. It does not function as a guarantor like it does for central government securities.
Risk Factors to Consider Before Investing
- Credit Risk (Implied): While not rated separately like corporate bonds, SDLs carry varying degrees of risk based on the financial health of the issuing state.
- Interest Rate Risk: SDLs, especially those with longer tenures, are sensitive to interest rate changes. In a rising interest rate environment, the market value of these bonds can fall significantly.
- Liquidity Risk: SDLs are not as liquid as central government securities. The secondary market depth is shallow, making it difficult to exit in emergencies without a price impact.
- Political Risk: Policy changes, populist spending, or political instability in a particular state can adversely affect its financials.
- Moral Hazard: Some states might borrow excessively with the belief that the RBI or the Central Government will bail them out in a crisis. This creates systemic risk over time.
What Does the Data Say?
According to RBI’s data, the aggregate gross fiscal deficit of states as a percentage of GDP has seen a significant jump post-COVID, touching close to 4% in some years, compared to the FRBM (Fiscal Responsibility and Budget Management) target of 3%.
Some states, like Punjab, Rajasthan, and West Bengal, have consistently breached fiscal norms, raising questions about long-term debt sustainability.
Additionally, state-level guarantees and off-balance-sheet liabilities—particularly in sectors like electricity, transport, and irrigation—pose contingent risks that are not immediately visible in the SDL structure.
How Mutual Funds Handle SDL Exposure
Many debt mutual funds, especially those in the “short duration,” “corporate bond,” or “banking and PSU” categories, invest in SDLs to enhance returns without taking corporate credit risk. However, SEBI mandates these funds to adhere to strict credit norms and asset quality filters.
Even then, during times of market stress, such as the Franklin Templeton crisis in 2020, SDL-heavy portfolios experienced redemption pressures. While the credit quality wasn’t the issue in that case, the lack of liquidity led to fund freezes.
This underlines an important point—return of capital is more important than return on capital.
Should You Invest in SDLs?
SDLs can be a part of your portfolio if:
- You understand the underlying risks.
- You have a long investment horizon.
- You are investing through instruments like gilt funds or target maturity funds that are SDL-based.
- You are not depending on liquidity (i.e., you’re okay holding till maturity).
However, direct investment in SDLs via platforms like RBI Retail Direct is best suited for informed investors who can analyze state finances—or are okay taking that additional risk for higher yield.
Final Thoughts – Don’t Be Lured by Yield Alone
State Government Bonds may appear to be a middle ground between central government securities and corporate bonds—offering higher returns with “perceived” government backing. But this is exactly where investors need to be extra cautious.
Before parking your money in SDLs, ask yourself a simple question: “Am I being paid enough to take this risk?”
In personal finance, the first rule is to never chase returns at the cost of safety. SDLs are not inherently bad, but like any other instrument, they require due diligence, understanding, and risk appetite.
Let your portfolio reflect your risk tolerance—not just your return expectations.
If you’re unsure whether SDLs fit your financial goals, it’s always a good idea to consult a fee-only financial planner.