MC EXCLUSIVE Moderation in investor appetite, high supply push state development loan yields up by 1% over 10-year G-sec

Bonds

The moderation in the investment by the long-term buyers such as pension funds, insurance companies, and provident funds and heavy supply by states in the State Development Loan (SDL) have pushed the yields 1 percent higher on this instruments over the government securities maturing in 10-year, money market experts told Moneycontrol.

Experts added that the moderation in the investment by long term players is due to reallocating funds toward equities in search of better return.

An analysis by Moneycontrol of the Reserve Bank of India’s (RBI) data showed that yield spread between 10-year State Development Loans (SDLs) and government securities has widened to a 5.5-year high. The spread stood at 1.0584 percent in early September, the highest since April 15, 2020, when it touched 1.1450 percent.

Umesh Kumar Tulsyan, managing director at Sovereign Global Markets said as the market navigates the tidal wave of volatility, rising yields and lower appetite of investment from domestic and foreign market players alike, demand for securities have taken a hit across the markets. “Institutions had already locked in yields at significantly lower levels than the present rates leaving them less or no room to add more securities to their portfolio.”

“As per the new PFRDA guidelines, pension funds can now park upto 25 percent of their funds in equity led schemes as compared earlier 15%. This has also led to shift in considerable portion of their debt investments to the equity markets, leading to additional demand shortage from the debt market,” Tulsyan added.

The widening spread comes as several states have borrowed significantly above the indicative calendar in recent auctions. On August 26, states raised Rs 28,892.036 crore, compared to a scheduled amount of Rs 20,850 crore. Similarly, on September 2, the actual borrowing stood at Rs 29,082.564 crore, well above the calendar projection of Rs 21,400 crore.

“The spread has widened primarily due to higher-than-scheduled issuances by states, especially in longer tenors. In some auctions, average maturities have extended to around 18 years,” said V. Ramachandra Reddy, DGM and Head of Treasury at The Karur Vysya Bank.

Experts said that since the release of RBIs new master direction in September 2023, commercial banks have parked a large amount of their HTM funds in SDLs to benefit from the spread gap against G-secs. Over a couple of years, almost 50 percent of their portfolio constitutes of SDLs. This consistency in demand and the falling interest rate scenario, boosted further confidence of states to increase their share of market borrowings.

FY26 has also seen a considerable rise in state borrowings in Q1 and Q2. Generally, state governments try to tap low-cost/interest-free funds in this time of the year before they turn to costlier market borrowings. However, with the Centre, accelerating infrastructure outlays and global headwinds threatening the economy, states appear to front-load borrowings to kickstart projects early.

While some states are utilizing these funds to accelerate infrastructure outlays, there is a possibility that few states are using such funds to service existing debt and interest repayments as well as to fund their populist schemes, Tulsyan added.

While both G-Secs and SDLs carry sovereign guarantee and qualify for Statutory Liquidity Ratio (SLR), SDLs typically have a higher yield of 40-50 bps over G-sec due to lower liquidity in the secondary market.

However, the current spread exceeding 100 bps reflects a significant shift in market sentiment amid higher issuances in primary market.

Some experts said that the SDL yields have risen in the last few weeks tracking the movement in the G-sec yield, especially after the GST reforms announced last month which led to the speculation that the central government may increase borrowings from market.

The 10-year benchmark bond yield,  a yard-stick or threshold for borrowing rates in the money market, spiked by 18-20 bps after the announcement of the recent GST reforms. The measures, while aimed at stabilising revenues and demand, raised speculation that the government might adjust its borrowing programme, which lead to an increase in bond yields.

However, bond yields eased after Sitharaman assured that the borrowing calendar will not be tweaked and that the fiscal deficit target remains on track. Her comments helped the bond market to ease pressure, with yields easing by 8-9 bps.

Analysts expect the SDL-G-Sec spread to remain elevated if state borrowing continues at the current pace and demand from institutional investors does not recover. A reversal in spread may depend on improved fiscal visibility for states and a more stable interest rate outlook.