Foreign investors’ interest in state government bonds cools4 min read . Updated: 11 Jan 2016, 01:41 AM IST
FPIs held Rs3,722 cr worth of SDLs as of 8 Jan, which is just 53% of the total Rs7,000 cr investment limit
Foreign investor appetite for state government bonds, also known as state development loans (SDLs), is waning as they expect the bond price to fall and yield to rise.
Increased borrowing by states in the January-March quarter and the impending impact of the additional burden due to revival plans by power distribution companies could lead to supply of such bonds outstripping demand, leading to a price fall, according to two custodian banks of foreign portfolio investors (FPIs).
The market for SDLs was opened to FPIs in September 2015 when the Reserve Bank of India (RBI) allowed FPIs to hold 2% of the stock of SDLs in tranches by March 2018.
From mid-October, FPIs were allowed to buy ₹ 3,500 crore in SDLs. The limit was doubled to ₹ 7,000 crore, starting 1 January. However, the initial zeal of FPIs for state paper waned as the newly enhanced investment limits remain unused even a week after they came into effect.
FPIs held ₹ 3,722 crore worth of SDLs as of 8 January, which is just 53% of the total available ₹ 7,000-crore investment limit. When the first ₹ 3,500 crore in SDL limits were made available to foreign investors, the limits were exhausted within days.
“Investors are going slow this time because there are concerns over the incremental supply and how the UDAY will impact state finances. It is understood that once the loans are converted into state bonds, these bonds will be bought by the banks themselves but the bonds will eventually find their way into the market," said an official of one of the banks cited above on condition of anonymity.
In November, the central government detailed a plan called Ujwal Discom Assurance Yojana or UDAY to revive power discoms and reduce the stress over banks’ loan books. The plan envisages converting 75% of outstanding bank loans to discoms into state government bonds over two years.
Rating agency ICRA estimates that this would result in an additional supply of state bonds worth ₹ 2.5 trillion in fiscal 2016 and ₹ 1.08 trillion in fiscal 2017.
It is unclear whether these bonds will remain only on the books of banks that have exposure to the discoms or if they would be open to all investors in the market.
Since these would not be eligible for statutory liquidity ratio (SLR) norm that normally spurs banks to buy SDLs, the demand for such papers is yet to be determined, ICRA added.
SLR is the amount of government bonds that banks have to mandatorily hold on their books. Banks can borrow against these bonds from the RBI’s borrowing windows.
State borrowings, and hence the supply of state bonds, is already high. States will borrow up to ₹ 1.05 trillion in the January-March quarter from the market through SDLs, a rise of 35% from a year ago. This is also the highest quarterly borrowing by states in at least five years, the RBI data showed. With this, the aggregate market borrowing by the states will rise 26% to almost ₹ 3 trillion for fiscal 2016.
This supply will push up yields, which have already moved north by about 10 basis points (bps) over the past one month. One basis point is one-hundredth of a percentage point. Bond yields and prices move in inverse directions.
While both central government securities and SDLs have a tacit sovereign backing since a state rarely defaults, FPIs view them differently.
“Since there is no explicit guarantee for a foreign investor, state loans are assessed differently from the sovereign. FPIs also differentiated between states based on their respective creditworthiness," said Manoj Rane, managing director and head of global market and treasury at BNP Paribas India.
“Also, there are foreign institutions that are not permitted to invest in state loans. This differential between state and central is not evident in the normal course of onshore trading, since local investors perceive the risk as similar," Rane added.
The financial health of different states varies and the same is reflected in the yield, or interest rate, that states pay on their SDLs. For instance, states such as Telangana, Uttar Pradesh and Madhya Pradesh, which are perceived to be riskier compared with others, pay a higher spread of 55-60 bps over the corresponding central government bond. States such as Maharashtra, Gujarat among others, which have healthier finances, can raise money at a lower yield.
Dollars will trickle in though SDLs over time but the pace is unlikely to match that of the central government securities, said the second custodian banker mentioned above.
FPIs paid a premium of 82 paise to gain access to an additional ₹ 5500 crore in central government bonds that was made available to them on 4 January, showing the strong demand for central government bonds.
Bankers add that the longer tenor of SDLs may also be playing a part in the slightly muted foreign investor demand. Most SDLs are 10-year bonds and fewer FPIs are willing to buy such long-term Indian paper.
“FPIs are largely yield-driven traders and arbitrageurs. Not too many large long-term investors put money into India via (the) FPI route," said Rane.