Borrowing costs of Indian states are likely to rise in the coming weeks as the Reserve Bank of India’s (RBI) rate hike cycle becomes more entrenched and the supply of state papers rises, money market experts and bankers told Moneycontrol on June 27. A majority of those expect the yield on the 10-year state development loan (SDL) to rise above 8 percent in the coming weeks.
“In the first quarter of this fiscal year, supply of debt was limited. But in the second half of this fiscal year, we expect state debt supply to rise and that should put upward pressure on (state) bond yields,” said Ritesh Bhusari, deputy general manager, treasury, at South Indian Bank.
To put in perspective, the cut-off yield for 10-year SDL ranged from 7.83 percent to 7.86 percent at an auction on June 21, according to data from the RBI. Prior to that, at an auction on June 14, Tamil Nadu’s 10-year paper was sold at a cut-off yield of 7.94 percent, while Haryana’s 10-year bond was sold at 7.95 percent. Nine states are scheduled to raise Rs 19,000 crore via bonds maturing in five years to 30 years this Tuesday. SDL auctions normally happen every Tuesday.
Investors typically demand a premium over central government bond yields, depending on the domestic and macro fundamentals and the fiscal position of the states. This premium is called the spread. The higher the spread, the greater the risk on the investment.
“We expect the spread between government securities and SDLs to rise to 70 to 80 basis points going forward,” added South Indian Bank’s Bhusari. “Right now, we have estimated that the net borrowing of states should be around net Rs 6 lakh crore for FY23, and it is very likely that the 10-year SDL yield rises to 8 percent to 8.25 percent in the coming weeks.”
Rising debt supply
Indian states had scheduled to borrow Rs 1.903 lakh crore from the debt market in April-June. Money market experts said that debt supply worries will increase from July as states increase spending to revive capital expenditure and as redemption pressures rise. This could lead to a rise in borrowing costs for states.
“Supply worries will increase from July and with interest rates normalising to a higher trajectory and liquidity surplus decreasing – all these factors can come together and contribute to higher state debt yields,” said Archita Joshi, chief manager, fixed income, at brokerage Motilal Oswal.
“The maturity pattern of SDLs indicates that the redemption pressure would start increasing from 2022-23 and would continue to do so till 2026-27. The upsurge in redemption necessitates consolidation of debt,” added Joshi.
More repo rate hikes in the offing
To make matters worse, the central bank is expected to hike rates further after raising its policy rate 90 basis points (bps) over the last two meetings, while also mopping up excess liquidity to tame inflation that is running above its target band.
The RBI’s monetary policy committee (MPC) increased the repo rate by 50 bps after hiking it by 40 bps at an off-cycle policy meeting in May. The repo rate currently stands at 4.90 percent.
“In case the US Federal Reserve delivers a 75 bps hike in the next scheduled meeting towards end of July (i.e., before RBI MPC meets next in August), and we lean towards that view also, then a 50 bps hike by the MPC is more likely,” said Abhishek Upadhyay, senior economist at ICICI Securities Primary Dealership.
This along with gradual liquidity absorption measures could mean further pain is likely for states when it comes to borrowing costs. Every SDL auction will be linked with G-sec yield movement, said money market experts.
“With all-time-high G-sec borrowing combined with continuous SDL large issuances over Rs 15,000 crore in every auction, the 10-year SDL yield should trade above 8 percent in the near future,” said Venkatakrishnan Srinivasan, founder and managing partner at Rockfort Fincap, a Mumbai-based debt advisory firm.
“As both SDL and corporate bonds spreads are linked with movements in government bond yields, it is expected that SDL yields will be volatile and every auction will be linked to how G-sec yields are behaving,” added Srinivasan.
‘Cherry-picking’ to continue
Experts said that banks will prefer to invest in fiscally better-off states. “Banks generally cherry-pick investments in SDLs. The trend has been that there is much more comfort in investing in fiscally prudent states like Gujarat, Tamil Nadu and Maharashtra over, say, the northeastern states,” said a treasury official at a private bank on condition of anonymity. “This trend may persist even in FY23.”
Since papers of fiscally better-managed states are more liquid, they are the go-to papers for banks in terms of investments in the held-to-maturity portfolio. HTM securities are securities that banks purchase and intend to hold until they mature.
“Banks prefer to cherry pick fiscally better states,” added Rockfort Fincap’s Srinvivasan.
RBI support key
Experts said that the RBI’s support in the government securities market will be crucial to keep states’ borrowing costs low. The RBI will not let go of the bond market, deputy governor Michael Patra had said June 24, adding that the central bank will aid the government's market borrowing.
“(The) RBI is reacting on an ongoing basis,” Patra said at an event in New Delhi. “This year we have to shift our gaze to inflation but we will not let go of the bond market and we will make dispensation of other types like the HTM.”
According to Motilal Oswal’s Joshi, if the RBI can manage to control the benchmark yield, states’ borrowing costs will automatically drop.
Some experts also said that states may have to depend on large state-run insurance companies and provident funds to mop up excess supply and keep yields low, say experts.“Large state-run insurance companies, provident funds, etc, do not differentiate states based on fiscal health as they consider all SDLs are risk-free instruments issued and serviced by the RBI,” said Rockfort Fincap’s Srinivasan. “That should help keep borrowing costs low.”