State Development Loans

MPE – Finance Specialization (09-11)

Group 3

Mayuri Potdar (117)

Shailesh Patel (109)
Vineet Mishra (82)
Contents

● General distribution of states debt

● What are State development loans?
● Purpose
● Issuer & Investor
● Concepts
● Features
● Risks & Rating Indicators
● Types of SDL’s
● General Guidelines & Requirements
● Markets
● Benefits & Recommendations
● References
General Distribution of State’s Internal Debt
What are State development loans?

○ State Development Loans (SDLs) are issued by the State Governments.

○ These Financial instruments are issued by government bodies to raise

resources from capital markets to permanently fund long-term capital
expenditures, and fund specific projects.

○ Bonds are issued by state governments in order to raise the money.

○ Generally, the coupon rates on State Development Loans are marginally higher
than those of GOI-Secs issued at the same time.
○ Government bonds are typically auctioned.

○ Bonds must be repaid at fixed intervals over a period of time.

Purpose of issuing State Development bonds
○ Shift the focus from distorted financial resource allocation based on a cash
subsidy program.

○ Make investing and resource raising feasible, which is an objective of the 74th
Constitutional Amendment.

○ Equipment financing

○ Project financing (toll roads, bridges, airports, water and sewage treatment
facilities, hospitals and subsidized housing).

○ Current tax revenue may not be sufficient to meet all expenditures.

○ Meet cash flow requirements basically time gap between the budget
sanctioned and disbursement.

○ Mitigation against exposure to interest rate risk through rate protected

instruments (cap, floor, swaps)
Issuer
○ The Issuer is the entity having legal authority to issue bonds.
■ States and their agencies
■ Municipalities
■ Redevelopment agencies
■ Special-purpose vehicles.
■ Public utility districts
■ Publicly owned airports and seaports
■ “On-behalf-of” entities
■ Any other governmental entity (or group of governments) below the state level.

○ Retail - High net worth individuals

○ Institutional - Funds or corporations
○ Mutual Funds
○ Commercial banks
○ Property and casualty insurance companies
○ crossover buyers - pension funds
○ Traditional bond buyers, hedge funds, and arbitrageurs
Concepts
■ Multiple Price Auction: Under a multiple price auction, every bidder gets
allocation according to his bid and apparently the issuer collects a
premium from all bidders quoting lower than the cut-off yield. The
drawbacks of the system is, occurrence of a phenomenon called winner's
curse.

■ Uniform Price Auction: In the case of this auction, competitive bids are
accepted at the minimum discounted price, called cut-off price,
determined at the auction, irrespective of the bid-prices tendered, below/at
the cut-off price.

■ Yield Curve: A curve on a graph in which the yield of fixed interest

securities is plotted against the length of time they have to run to maturity.

■ Yield: The income from an investment. The nominal yield of a fixed

interest security is the interest it pays, expressed as a percentage of its
par value.

■ Cut-off Yield: Cut-off yield is the yield at which or below which the bids are
accepted.

■ Redemption Yield: The redemption yield or yield to maturity covers the

current yield plus the capital gain or loss divided by the numbers of years
to redemption.
Concepts
○ Open Market Operations (OMO): The purchase or sale by a Government of bonds in
exchange for money.

○ Bench-mark Rates: In developed markets, Treasury Bill rates set the course of other
short term rates in the system. In India, the cut-off yield rates arrived through the
competitive bids received in the auctions of Treasury Bills have emerged as
benchmark short term rates. Since April 1997 Bank Rate has been activated as a
bench-mark rate.

○ Primary Dealers (PDs): Primary Dealers are market makers in government

securities. They have a minimum threshold limit of Net Owned Funds of Rs.50 crore
and are expected to strengthen the government securities market by acting as
underwriters and market makers with commitments to bid in auctions and to offer
two way quotes.
Features
● Coupon or Interest
○ Fixed or Variable interest rate – max. limit capped
○ Reference rate + Spread
○ Types :
■ Inverse floating rate issues – coupon opposite to ref. rate
■ Original issue discount – 0 coupon bonds
■ Accrued interest bonds

● Maturity
○ Tenure generally is 10 years
○ Serial bonds - Scheduled to mature serially over many years

● Legal Opinion
○ To check the risks & legal aspects of the issue
○ Check on
■ Issuer’s ability to legally issue the bonds
■ Rules & regulations followed
■ Security safeguards are supported by govt’s laws & regulations
Features
● Taxability
○ Mostly Tax – free, some taxable – depending on project
○ Interest income – tax –free, capital gains - taxable
○ Project for public good, govt owned or private – tax free interest
○ Projects for private benefits – private activity bonds – taxable interest

● Ratings
○ Credit ratings help investors appraise the risk and reward of the bond.

● Acutions

○ Multiple price auctions, through competitive bidding, conducted by Reserve

Bank of India and allotment procedure is similar to that for GOI-Secs.
○ Non-competitive bidding has still to be introduced.
○ Issued in dematerialized form.
○ State Government Securities are also issued in the physical form (in the form
of Stock Certificate) and are transferable.
○ No stamp duty is payable on transfer of State Development Loans.
Risks involved with Municipal
Bonds
Credit Risk:

- Issuer may fail to make scheduled interest payments

- Issuer may be unable to repay the principal upon maturity

- Issuers creditworthiness is evaluated by rating agencies

Interest Rate Risk:

- Interest Rate of most municipal bonds is paid at a fixed rate

- Interest rates rise will pay a lower yield on the bonds

Tax Bracket Changes:

- Municipal Bonds generate tax free income and pay low interest rates

- Drop in income tax rate are not beneficial to investors as they can get better yields
from taxable bonds

Market Risk:

- Until maturity, not a factor because your principal investment will be returned in full at
maturity
Rating Indicators of State Government
loans/Munis.
State Government Ratings
Economic Structure
● Net state domestic product (NSDP) composition and growth rate.
● Per capita NSDP and growth rate.
● Demographic profile.
● Per capita availability of education and heath facilities.
● Per capita availability of power, roads, railways etc.
● Per capita sanctions and disbursements by financial institution.
● Mineral Reserves.
State Government Finance
● Revenue Receipts and expenditure
● State’s own revenue/ total expenditure.
● Grants from Centre/Revenues.
● Revenue Deficit
● Fiscal deficit and its composition
● Gross fiscal deficit/NSDP
● Debt/NSDP
● Capital expenditure/Fiscal deficit
● Revenue Receipt/Interest.
Economic Mangement
● State Government guarantees.
● Utilization of ways-and-means, advance and overdraft facility.
● Performance of state-level public sector undertakings.
● Plan Performance.
Municipal Bonds Issuance Process
General Format of SDL’
s General Obligation Bonds Revenue Bonds Commercial Papers
(GO)

Issued to: Raise immediate capital Fund infrastructure Meet short term cash
projects requirements

Features: 1. Most common 1. Riskier Offer low yields

2. Least risky 2. Offer high yields
3. Offer the lowest yield than GO bonds
4. Not tied to a particular project.
5. Issuer is obligated to pay
interest and principal on time

Backed By: Issuers ability to tax or taxing Income generated from Letter of Credit from a
power of the issuer projects bank
Markets & Process of Issuance
● Primary Markets
○ Directly from issuer at time of issuance
○ Issuer’s official offer statement – disclosures
○ Credit rating of bonds by independent rating agency
○ Issuer receives cash payment in exchange for a promise to repay
○ Bondholder receives payments over time composed of interest on the invested
principal, and a return of the invested principal itself
○ Process – Deals, Auctions or Private Placements

● Secondary Markets
○ From other bond holders at sometime after issuance
○ Trade as interest rate spreads to the existing bonds.
○ Liquidity helps in ascertaining a fair price for these bonds and the associated
risks
○ Bondholder receives payments over time composed of interest on the invested
principal, and a return of the invested principal itself
○ Process – OTC
US Markets

○ Largest & well developed primary & secondary markets

○ $850 billion – as of Jan 2005

○ 55000 active issuers - Bloomberg

○ 2.6 million issues

○ Daily prices of 1.4 million issues

○ Issues sizes from $ 1 m to Billions

○ Denominations of $5000 or multiples

○ All varieties of bonds on offer

Indian Markets

● 1st issuance – 1997 - Bangalore Mahanagarapalika

○ Rs 100 crore, Coupon - 13% p.a., Maturity – 7 yrs
○ Rating - CRISIL A(SO) indicating adequate safety
○ Mode - Private Placement & guaranteed by the Government of Karnataka
○ Payments secured by way of structured payments mechanisms i.e. collection
and deposit of property tax and government grants to a designated Escrow
account
○ Purpose - development of roads, side drains and street lighting in Bangalore
City

● 1st Public offering – 1998 - Ahmedabad Municipal Corporation

○ Rs 1 billion, Coupon - 14% payable semi-annually
○ Structured obligation - Redemption in 3 tranches Rs. 333, 333 & 334 per Rs
1000 at the end of 5th, 6th and 7th year
○ Rating – CRISIL AA(SO)
○ Mode – 75% Private placement, 25% Public issue
○ Payments secured by charge / mortgage on properties of AMC
○ Purpose: Octroi collection from 10 designated collection points were
specifically earmarked for servicing the bond and kept in an Escrow account
Benefits of Municipal Bonds
○ Interest received is generally exempt from income tax
○ Municipal bonds have a higher after tax yield than corporate bond with same
rate
○ State Development Loans are eligible securities for Liquidity Adjustment
Facility (LAF)-Repos.
○ State Development Loans also qualify for SLR status.

Recommendations to Increase Liquidity

○ Create a separate trading platform for bonds

○ Higher incentives for retail investors (Tax breaks beyond 8% & capped value)

○ Increase bonds with flexible coupon rates or coupon mapped with interest rates
prevailing in the market
Bibilography

● www.rbi.gov.in
● www.wikipedia.com
● www.Investopedia.com
● http://en.wikipedia.org/wiki/Municipal_bond#Comparison_to_corporate_bonds
● http://www.bing.com/search?srch=106&FORM=AS6&q=2.
1+Why+Municipal+Governments+borrow+money
● http://urbanindia.nic.in/moud/programme/ud/g_issue.pdf
● http://www.economywatch.com/bonds/municipal/
● http://beginnersinvest.about.com/cs/municipalbonds/a/aa071502.htm
● http://www.investopedia.com/articles/bonds/05/022805.asp?viewed=1
● http://www.projectsmonitor.com/detailnews.asp?newsid=6884
● http://www.developmentfunds.org/pubs/ADB%20India%20report.pdf
● http://ibnlive.in.com/news/state-of-our-cities-investors-and-municipal-bonds/77860-
3.html
● http://www.niua.org/present_series/syndey/sydney_paper.pdf
● http://www3.iclei.org/localstrategies/summary/ahmedabad2.html
http://newdelhi.usembassy.
gov/uploads/images/INLpQ9XdIueYxem5k4iaBw/wwwfpppusaid.pdf
Thank you