States raise funds from the market up to a prescribed limit through the Reserve Bank of India (RBI) for various social developmental projects. One of the ways is by issuing bonds called state development loans (SDLs), which usually come with a tenure of 10 years or more.

With interest rates peaking, these long-duration securities are now gaining traction. Given their higher yields,  SDLs could be a good investment alternative to fixed-income assets.

What Is It?

• SDLs, typically, have a tenure of 10 years. Now, some states are coming up with shorter-tenure SDLs too.
• They are low on risk as they are similar to sovereign government bonds, but have a yield that is 25-50 basis points more.
• These are issued digitally on RBI’s Retail Direct platform.
• They are sold through auction by RBI and RBI-appointed primary dealers on behalf of banks, MFs, insurers, provident funds, etc.
• They can also be bought and sold in the secondary market through RBI’s Negotiated Dealing System (NDS) electronic trading platform.

What Do They Offer?

• They come with sovereign guarantee as the interest and principal payments are serviced by RBI.
• The interest rates are usually higher than that of central government securities and bank fixed deposits. Typically, it is 6.5-7.5 per cent, based on tenure and interest rate outlook.
• Interest is payable half-yearly, and the principal is paid on the maturity date or on redemption.
• The interest amount is taxable at the marginal tax slab rates if withdrawn at maturity. If sold in the secondary market before 1 year, short-term capital gains tax will apply. If sold in the after a year, long-term capital gains tax will apply.

Should You Buy?

• Though they are low-risk instruments, the interest rate and risk perception vary, depending on each state’s financial position.
• Retail investors can participate in SDL auctions only through RBI Retail Direct platform, so the option is limited.
• SDLs are illiquid compared to government bonds. There are no guarantees on the price you will get in the secondary market as it will depend on the interest rate scenario.
• Invest only if you can hold till maturity—remember that the tenure is long—and if you want to diversify your fixed income portfolio.