Spread between 10-year SDLs, G-Secs narrows to historical low on high demand from investors

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The spread between 10-year state development loans (SDLs) and the benchmark Government Securities of similar maturity narrowed to a historical low as rising demand lowered the cost of borrowing by states to 7.77 percent, dealers said.

The spread between SDLs and G-Secs currently hovers at 25 to 30 basis points, which is considered a historical low, according to data compiled from market sources.

In 2016, the spread was 32 basis points, just above the current level. During 2020 and 2021, it was about 67 basis points and 88 basis points, respectively.

SDLs are similar to the Central government’s dated securities and are issued by states that borrow to meet their budgetary needs. Each state can borrow up to a specified limit through these securities.

The reduction in the spread has actually helped SDL issuers because after the first rate hike by the Reserve Bank of India in this financial year, yields on 10-year government securities till date increased by 15 basis points and simultaneously yields on SDLs rose by only 6-7 basis points.

One basis point is equal to one-hundredth of a percentage point. When bond yields go up, prices go down, and when bond yields go down, prices go up.

Lower supply

Yields on state loans did not rise sharply because most investors in search of higher yields shifted their investments to SDLs, leading to higher demand for these securities. The lower spread between these securities and firm yields on SDLs will allow more states to borrow from the market, considering the higher demand, a dealer with a state-owned bank said.

The spread is the difference between two prices, rates, or yields. In this case, it is the difference between the last traded yield on 10-year SDLs and government securities of similar maturity.

According to Umesh Kumar Tulsyan, managing director of Sovereign Global Markets, a New Delhi-based fund house, SDL supply has been lower than the calendar amount announced by the RBI, while demand for long-term paper has gone up drastically.

He said demand from investors like Employees Provident Fund Organisation, Life Insurance Corporation of India, pension funds and other retirement trusts for SDLs has gone up as they fetched the highest yield.

“The lowest spread that we have witnessed was 25 basis points over government securities,” said Tulsyan.

Since the start of this financial year, states have been borrowing less through SDLs than the amounts stated in the indicative borrowing calendar. This was because of higher collections of goods and service tax in the first half of the financial year and lower-than-budgeted spending by the states.

Borrowing by states in the first quarter was Rs 1.10 lakh crore, or about 40 percent lower than the Rs 1.90 lakh crore planned, while in the second quarter, it was Rs 1.58 lakh crore, or 25 percent lower than the Rs 2.12 lakh crore proposed, as per data compiled from RBI website.

However, experts said state spending should go up in the second half of FY23, as indicated by the trend in previous years. Hence, borrowing will not be less than the notified amount for the next two quarters, money market dealers said.

“Historically, states borrow more in the last two quarters and they will step up as and when they see the right opportunities,” said Ajay Manglunia, managing director at JM Financial.

Borrowing costs

Higher borrowing will lead to a rise in borrowing cost for the states. Such costs have already started increasing, as seen in the previous weekly SDL auction. The average 10-year borrowing cost for states increased by 11 basis points on-week on October 3, when 10 states raised Rs 19,500 crore through SDLs.

However, there is pressure on short- to medium-term papers now because of the high demand for long-term bonds. In the previous SDL auction, the cut-off on the 8-year Maharashtra SDL was almost equivalent to the 10-year SDL and 10 to 15 years papers were near the 10-year SDL.

Manglunia said investors are not sure about the yield trajectory. They have been careful and will continue to be so until there is clarity on the geopolitical front. As of now, the fight against inflation has forced central banks globally to increase interest rates and India has to take similar steps.

Last week, the RBI increased the repo rate by 50 basis points to 5.90 percent to combat inflation. The central bank had increased its policy rate by 140 basis points between May and August.