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According to data from rating agency India Ratings, state government borrowings have increased nearly 10 times over the last decade. Photo: Bloomberg
According to data from rating agency India Ratings, state government borrowings have increased nearly 10 times over the last decade. Photo: Bloomberg

Fiscal worries push up yields on state bonds

Yields differ between states at auction of SDLs; West Bengal pays the most, Odisha the least

Mumbai: Investors are demanding higher yields on state government bonds and also appear to be differentiating between states based on their fiscal position and the quantum of losses accumulated by their power distribution companies.

An indication of this came through during the auction of state development loans (SDLs) on Tuesday where the yield at which state securities were bought was higher than previous auctions and also differed from state to state. For instance, Maharashtra raised 1,500 crore at an interest rate of 8.67% for a period of 10 years. However, most other states had to pay more.

Bihar raised 2,500 crore at a yield of 8.82%, while West Bengal paid the most and shelled out a yield of 8.88% to borrow the same amount.

The lowest yield was seen for SDLs of Odisha where the state paid 8.48% to borrow 1,000 crore for a period of five years.

Bond yields and prices are inversely correlated.

“Earlier, the difference in yields between states was hardly a few basis points; but, as seen in this auction, investors seem to be differentiating. As a first thought, it is possible that investors are differentiating based on the impact of the UDAY scheme, but one would need to study the numbers closely to come to that conclusion," said R. Sivakumar, head-fixed income, Axis Asset Management Co. Ltd.

In November, the central government detailed a plan called Ujwal Discom Assurance Yojana, or UDAY, to revive power discoms and reduce the stress on banks’ loan books.

The plan envisages converting 75% of outstanding bank loans to discoms into state government bonds over two years. State electricity boards (SEBs), which control the discoms in their respective states, owe nearly 4 trillion in debt to the banking system.

The impact of the scheme is likely to play out in the bond market in two ways. Firstly, as the outstanding stock of state government securities will rise due to the conversion of discom loans into state government bonds, the price of these bonds may be under pressure.

At the same time, as banks will be holding these bonds as part of their investment books, the appetite from banks to participate in future state government bond auctions may reduce, which in turn will bring down demand and push up yields further.

To be sure, the UDAY scheme may not have been the only factor behind the relatively high yields. “Another factor at play may have been the relatively large size of the auction on Tuesday," added Sivakumar.

Overall, states borrowed 21,445 crore through Tuesday’s auction.

Yields on state government securities have also risen because of the steady and continuous increase in borrowings from states. States will borrow almost 3 trillion from the market in fiscal 2016, an increase of 26% over the previous years. According to data from rating agency India Ratings, state government borrowings have increased nearly 10 times over the last decade.

In 2005-06, states borrowed 391 billion, but this figure has now gone up to 3 trillion and could rise further.

While supply has risen, demand has not. In fact, a reduction in the mandated bond holdings for banks, as part of the statutory liquidity ratio requirement, has been steadily reduced to 21.5% from 22.5% in August 2014. Attempts to bring foreign investors into the SDL market have also seen limited success and only 57% of the available limit of 7,000 crore has been taken up.

This mismatch between supply and demand has meant yields on state government securities have steadily risen. “The SDL auction found takers at yields between 8.63-8.88% for 10-year maturity bonds. The 10-year benchmark G-sec (central government bond) yield is currently hovering around 7.82%, indicating a spread of 80-105 basis points. The spreads are sharply higher than the average spread of 39-45 basis points at the start of 2016," said Soumyajit Niyogi, associate director at India Ratings.

One basis point is one-hundredth of a percentage point.

Niyogi said the increased borrowings, the size of the auction and the uncertainty over the UDAY scheme have all been factors in the increase in yields.

“Interstate spread differential has considerably widened from the last couple of SDL auctions from an average of +/-5 basis points to over 25 basis points.

In India Ratings’ view, the interstate widening of spreads can be attributed to higher issuances by a few states and possible differentiation on account of credit quality and liquidity issues," said Niyogi.

Sivakumar of Axis Asset Management, said the increased borrowings and higher yields on state government securities are also having an impact on yields of central government bonds.

“The rise in state bond yields have made them more attractive to investors which in turn may reduce demand for central government bonds from investors who have mandates to invest a certain amount of their corpus in government bonds irrespective of whether they are central government or state government securities," said Sivakumar.

On Tuesday, central government bond yields jumped following the results of the state government auction.

The benchmark 10-year bond yield closed at 7.82%, compared with 7.77% on Monday.

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