Yield spread between state bonds and g-sec widens to two-year high

The yield spread widened to 53 basis points on Tuesday. The last time the yield spread widened above 50 basis points was in January 2022

The spread between yields on the 10-year state bonds and the benchmark 10-year government bond widened to a two-year high due to large supply of state bonds during the last quarter of the current financial year. 

The widening of yield spread indicates a growing disparity in borrowing costs between states and the central government. Consequently, states may have to shell out more to raise funds compared to the sovereign.

The yield spread widened to 53 basis points (bps) on Tuesday. The last time the yield spread widened above 50 bps was in January 2022, according to data compiled by rating agency ICRA.

States and union territories are scheduled to borrow a whopping Rs 4.1 trillion during January-March. Half of the total borrowing is attributed to Karnataka, West Bengal, Madhya Pradesh, and Tamil Nadu. Notably, Karnataka and West Bengal are expected to contribute significantly to the substantial incremental borrowing of Rs 1.1 trillion in the last quarter.

This marks a 37.4 per cent year-on-year (Y-o-Y) increase in borrowing by states, on the back of an already large issuance of Rs 3 trillion in Q4 FY23.

Analysts said the yield spread may widen up to 60 bps during the quarter if the states borrow the indicative amount.

“In our view, if the weekly state government securities (SGS) auctions in Q4 FY24 are closer to the indicated amount, the spreads between the 10-year SGS and 10-year G-sec yield may widen to 50-60 bps in this quarter, especially in February-March 2024,” said a report by ICRA.

The spread between the weighted average 10-year SGS and 10-year benchmark G-sec yield widened to 40-48 bps in the last quarter. It mainly reflects the higher-than-indicated SGS issuance in seven of the 13 weekly auctions of the quarter.

During October-December, states were scheduled to issue bonds worth Rs 2.37 trillion. However, the actual borrowing in the quarter exceeded the indicated amount by 4 per cent or Rs 8,700 crore, according to the report. The average spread stood between 30 and 35 bps in the first and second quarters.

Meanwhile, analysts said states may not borrow the entire amount. They may borrow up to Rs 3.5 trillion during the quarter.

“We don't expect the supply to be this large. It should be lower. We feel that some states will end up borrowing less. In terms of supply, it's not expected to be Rs 4.1 trillion, but around Rs 3.5 trillion,” said Gaura Sengupta, economist at IDFC First Bank.

During the second quarter, states had borrowed Rs 1.9 trillion, which was about 80 per cent of the indicated amount. In the first quarter, states had borrowed 84 per cent of the notified amount of Rs 1.9 trillion.

“It's actually more a function of whether they go through with the calendar or not. Traditionally, they haven't gone through the calendar. I don’t think they have the capacity to spend Rs 4 trillion in a quarter. It also depends upon devolution as well as grants,” said Vikas Goel, managing director (MD) and chief executive officer (CEO) at PNB Gilts. “The spread should narrow gradually on announcement of amounts less than what is in the calendar,” he added. The central government released Rs 1.46 trillion to states through two instalments in December.

The government transferred the amount to states as tax devolution for financing various social welfare measures and infrastructure development schemes.

In 2022-23, states’ gross fiscal deficit (GFD) stood at 2.8 per cent, lower than the budgeted estimate of 3.2 per cent. A notable reduction in revenue deficits has been the primary driver of this fiscal consolidation.

For 2023-24, states have budgeted a GFD-gross domestic product (GDP) ratio of 3.1 per cent, well within the Centre’s limit of 3.5 per cent, according to the Reserve Bank of India’s (RBI’s) Financial Stability Report.

Despite these efforts, outstanding liabilities of states still surpass 20 per cent of gross state domestic product (GSDP), exceeding the limit recommended by the FRBM Review Committee (2018).

Larger states, in particular, exhibit debt ratios exceeding 35 per cent of GSDP. This poses redemption pressure in the medium term. Additionally, the reinstatement of the old pension scheme (OPS) by some states may impact their capacity to undertake developmental and capital expenditures.