Karnataka took the expected populist turn in its state budget to announce that loans to farmers would be waived and the government will foot the bill—₹ 34,000 crore, to be precise. With this, the Karnataka government joins Rajasthan, Maharashtra, Punjab and Uttar Pradesh that have already announced farm loan waivers in the past one year.

State budgets are already stretched and the central government would be hard-pressed to avoid other populist measures ahead of 2019 Lok Sabha elections. Analysts are already working out a potential flare-up of the fiscal deficit. Bank of America Merrill Lynch expects farm loan waivers to balloon to roughly 2 trillion by the time national elections begin.

So, it is not surprising that rising government bond yields have got another reason to stay on their upward journey. The benchmark 10-year bond yield is just shy of 8% now mainly because the other big news of minimum support prices largely met with market expectations. But central government securities are not the centre of the pain in the bond market.

Look no further than state bonds or state development loans as they are called. Yields on these have risen 5-25 basis points roughly over the past one month. Part of this is, of course, mirroring that of government bonds as all sovereign papers tend to move unidirectional.

A large part of the pain in state bonds is a new Reserve Bank of India (RBI) ruling that mandates investors to mark them at market prices. The regulation earlier was to put a standard 25bps mark-up to the corresponding government bond to value state papers.

Since banks—one of the largest investors in state bonds—now have to price them realistically at market levels, each paper would better reflect the fiscal health of the state it belongs to. Karnataka has not borrowed yet in the current fiscal year but as per an indicative calendar, the state looks to mop up around 8,000 crore during July-September.

It would surely have to cough up more than the 8.03% it paid at an auction in January. The new valuation rule for state bonds has made banks cringe as they would have to take a mark-to-market hit greater than previously anticipated. And, after this one-time hit, banks will likely cherry-pick state bonds.

That would result in much-needed differentiation between states. Meanwhile, central government bonds could continue to be weighed by the issuer’s potential to swing to a wider fiscal deficit.

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