State bond yields offer a mirage of financial health thanks to liquidity
With the focus back on the deteriorating finances of states in the wake of farm loan waivers, one would assume that their bonds, also called state development loans, would have been hit.
It should be obvious that the five states that have announced farm loan waivers may have to cough up more to borrow from the bond market in future as their stretched balance sheets start to split at the seams from these waivers.
But a look at the five states shows that the yields do not reflect the weakened fiscal position.
States borrow from the bond market through an auction process which the Reserve Bank of India conducts according to the borrowing plan of a state. Telangana and Punjab have witnessed a fall in their bond yields in the latest auctions. Maharashtra is perhaps the only state that has seen its bond yields rise. The state borrowed Rs2,000 crore through bonds on 23 May at a yield of 7.51% while its bonds were traded around 5-10 basis points lower in the secondary market weeks before the auction. Karnataka and Uttar Pradesh have not borrowed so far in the current fiscal year.
The key culprit for the fall in yields is the excess liquidity in the banking system. Investors are chasing yields and state bonds being quasi-sovereign are appealing from an investment point of view.
Another gauge would be to look at state bond yields as a spread over the comparable government bond yield. After all, the sharp fall in the yield on central government bonds is sure to rub off on other securities as well.
The spread between Telangana’s bond yield and the central government bond yield has contracted to around 10 basis points now from a little over 15 basis points in early April. However, given that 20-year government bonds are hardly traded, this pricing may also be fraught with issues. That of Punjab has contracted to 76 basis points now from 81 basis points a month back. This spread for Maharashtra’s bonds has widened.
It is evident that state bond pricing is not scientific and depends mostly on the extent of demand and the profile of buyers.
To be fair, the premium that states have to offer over central government securities has been widening over the last one year. A Mint article on 25 April shows how states have indulged in fiscal profligacy over the years and have felt the pain on pricing their bonds.
Nevertheless, investors need to relook at bond prices of some states in light of the pressure these farm loan waivers will put. Foreign portfolio investors are already taking note of this and staying away from state bonds.