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State loans emerge as a dependable asset class

In the past few years, supply of state development loans and trading volumes have picked up sharply.

State development loans, or SDLs, are finally getting the attention they deserve from asset managers at domestic mutual funds, pension funds and insurers. This is because of a large increase in supply and remarkable returns over the past 5 years. These sub-sovereign papers have, in fact, beaten or matched lower-rated AAA securities in recent years.

The Indian debt market is dominated by government securities (G-secs). The corporate bond market remains insipid despite much discussion around its development over the past couple of decades. SDLs, used by state governments to fund their fiscal deficit, have also not enjoyed the respect due to a dynamic asset class until recently. 

The lack of interest in SDLs was largely because of limited supply. Trading volumes were lower because banks and pension funds would typically hold these papers for statutory reasons. 

The past few years have, however, seen consistent growth in supply of SDLs and the trading volumes have also picked up sharply. SDLs outstanding touched Rs20.9 trillion, and G-secs Rs46.53 trillion, as on 31 March 2017. Today, SDLs enjoy a higher share in allocation of asset managers, especially insurance companies and mutual funds. 

With this, SDLs have emerged as a snug fit between G-secs and corporate bonds, both in terms of credit risk and as a floor for spreads of corporate bonds over G-secs. 

Superior risk-adjusted performance 

The sub-sovereign status of SDLs means they involve lower credit risk than AAA-rated corporate bonds. From a credit risk perspective, it would be worth emphasising that SDL issuances and repayments are managed by the Reserve Bank of India (RBI), which prescribes 0% risk weight for such papers held by commercial banks. SDLs are also repo-able at the RBI’s liquidity adjustment facility window and qualify for both statutory liquidity ratio requirement and to fulfil the quota of investment in G-secs prescribed by other regulators such as the Insurance Regulatory Development Authority of India.

Despite this, a Crisil Research study indicates, SDLs have outperformed AAA-rated corporate bonds’ portfolio in six of the past 12 years and have given better returns over 1, 3 and 5 years.

The study compared the performance and attributes of the newly launched CRISIL 10 Year SDL Index—which comprises the most liquid securities of 12 states that accounted for 81% of the issuances and 89% of the traded volume in financial year 2017—with that of CRISIL AAA Long Term Bond Index. Though the interest rate risk for SDLs is higher, as measured by modified duration, the duration gap of these two indices has narrowed significantly in the past 2 years (see chart). 

SDL issuances have spurted following the Twelfth Finance Commission recommendation (2005-10) for doing away with central assistance to state plans in the form of grants and loans, and a reduction in National Small Savings Funds collections to finance state deficit. 

Between fiscal 2010 and 2017, issuances have risen three-fold, even as Maharashtra, West Bengal and Tamil Nadu have emerged as the top three interstate borrowers. The 10-year maturity segment remains the predominant tenure, accounting for the majority of issuances and trading volumes.

Over the past couple of years, the Ujwal Discom Assurance Yojana (UDAY) has emerged as the key factor for growth in supply. In fiscal 2017, issue of UDAY bonds, at Rs1.09 trillion, were almost a third of the SDL issuances of Rs3.81 trillion. 

Significant attempt has also been made to promote foreign portfolio investment in SDLs, with the government progressively increasing the limits since October 2015. Effective July 2017, the investment limit has been revised to Rs33,100 crore, up from Rs27,000 crore. This is expected to boost foreign participation in the SDL market further, particularly given that state bond returns in India are attractive compared with other emerging markets. 

Interestingly, the traded volumes grew at a higher rate than issuances between fiscal 2010 and 2017, indicating improved liquidity and price discovery (see chart). As of 31 March 2017, SDLs traded at a spread of 89 basis points (bps) over the relevant 10-year benchmark, mainly given a demand-supply mismatch. One basis point is one-hundredth of a percentage point.

However, there have been some spread differentials among states, depending on their perceived credit quality, liquidity and fiscal health. Also, with the advent of UDAY bonds since November 2015, to grant respite to the state power distribution companies, the outstanding amount of state government securities has risen, putting pressure on the prices. 

The investment patterns of debt mutual funds also indicate a growing interest in SDLs. The Crisil study shows that gilt funds’ exposure to SDLs, as a percentage of their assets under management (AUM), was 20% (the highest since 2005) as on 30 April 2017. The average month-end exposure to SDLs rose from 4% in fiscal 2016 to 9% in fiscal 2017. Similarly, the average exposure of debt and debt-short mutual funds to SDLs increased to 4.38% in fiscal 2017 compared with 1.44% in fiscal 2014.

The trend holds for life insurers and retirement funds, too, given the asset managers’ search for better liquidity and higher yields (see chart). 

If anything, mutual funds, pension funds and insurers need a robust valuation approach for SDLs. 

Jiju Vidyadharan, director-funds and fixed income research, Crisil Ltd

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