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Informist, Tuesday, Sept. 2, 2025

 

MUMBAI – State bonds have added to bond traders' anguish recently and the market is making the issuers pay the price. The yield spreads of 10-year state bonds at Tuesday's auction widened to 106-112 basis points over the benchmark 10-year gilt issued by the Centre, surpassing the much-feared 100 bps mark, and the highest spread since April 2020. The spread Tuesday exemplifies the pressures building up in both the complementary markets over the past few weeks.

 

The Reserve Bank of India set a cut-off yield of 7.63% on Assam's 10-year bond, higher than an Informist poll estimate of 7.55%. The central bank set a cut-off yield of 7.69% on Meghalaya's 10-year bond, also higher than a poll estimate of 7.60%. Twelve states raised INR 290.83 billion at the auction Tuesday, lower than the notified amount of INR 316.50 billion. However, secondary market prices rose after the result, since cut-off yields on the long-term state bonds were lower than expectations, indicating demand from the Employees' Provident Fund Organisation and life insurers in the 30-year state bonds. Investor demand helped the cut-offs remain lower than the 7.75% median seen in an Informist poll. Maharashtra and Tamil Nadu rejected bids for bonds maturing around 30 years, another boost for long-term bonds. 

 

"Maharashtra didn't raise some bonds last week, this time also they didn't," a dealer at a private sector bank said. "It's not that they don't need the money, they wouldn't come to raise funds if they didn't, but it shows that they're not comfortable with the levels (bids) they're getting."

 

Maharashtra, a state which traders usually flock to, did not accept a single bid for any of the four bonds it aimed to issue last week. It is a sign that no state was exempt from traders' reluctance to buy, dealers say. Several bond dealers have reached their internal limits on investments in state bonds, and refuse to hold any more stock due to low appetite for risk. Demand from state-owned banks, which usually buy these bonds for their investment books, has been subdued, which led to a higher-than-view cut-offs on the 10-year bonds at Tuesday's auction, while a semblance of investor demand pulled longer-term state bond yields lower than expectations. Telangana, Rajasthan, and Kerala accepted one bid each on some long-term bonds on tenures of 30 years or more. 

 

"The spreads between the state government securities over the central government securities (in the 10-year segment) have gone over 100 basis points, and are likely to hit all time highs," said Arvind Kanagasabai, head of treasury at Tamilnad Mercantile Bank. "The spreads will remain high as banks have internal limits on how much state bonds they can have as part of SLR (statutory liquidity ratio requirements), and additional buying may be weak as these limits are nearly full."

 

Traders said that a 100-bps yield spread was inevitable this month due to an overload of supply met with subdued appetite. Fourteen states raised bonds worth INR 288.92 billion at the auction last week, against a notified amount of INR 341.50 billion. The cut-off yield on Jammu and Kashmir's 17-year bond at that auction was set at 7.82%, while the cut-off on a 21-year bond it issued at the last auction in June was 7.08%. Traders are shying away from these bonds due to their illiquidity in an increasingly volatile market. The 10-year gilt's average daily trading range was 6 bps in August, compared with 2 bps in July.

 

In August, the 10-year benchmark 6.33%, 2035 gilt yield rose 19 bps. The yield spread of the 10-year gilt over the repo rate of 5.50% is well over 100 bps, on fears of increasing gilt supply, lack of signals from the central bank that indicate scope for rate cuts, and meagre appetite from long-term investors, market participants say. Stop-losses have added to the recent slump in secondary bond prices, with traders reducing their stop-loss filters to every 1-2 bps. 

 

The warning bell tolled in early August, when six states raised INR 84.50 billion through bonds, much lower than the scheduled amount of INR 147.00 billion. Traders had expected the state bond auction result to be a "non-event" due to its small size. However, the cut-off yield on Maharashtra's 7.16%, 2055 bond was set at 7.42%, sharply higher than 7.33% in an Informist poll. Traders were expecting a maximum cut-off of 7.36-7.37% for the bond. The result sparked fears of weak demand from long-term investors. A weak auction result combined with fiscal concern sent the benchmark 10-year yield up 5 bps by the end of the session on Aug. 12.

 

Even with this, states are just about meeting their indicated borrowing in the Jul-Sept calendar, having borrowed INR 2.08 trillion so far, against an indicated amount of INR 2.13 trillion in the same period. This includes rejection and partial acceptance of bids. States usually borrow less than their targets, but traders are comfortable even if the borrowing is at par this quarter, since INR 2.87 trillion--the target set for the quarter--was lower than market expectations of INR 3.0 trillion. The pain point is the longer-tenure borrowing, dealers say. The weighted average maturity of the bonds being issued is over 17 years, according to dealers, a tenure looked upon unfavourably in times of volatility. Given the see-saw in the secondary bond market, traders risk burning their fingers if they need to dump illiquid state bonds--which have larger bid-offer spreads--than liquid securities.

 

Traders are already facing heavier long-term supply from the central government due to lukewarm participation from the usual long-term investors such as insurers and pension funds. In Apr-Sept, the share of long-term borrowing by the Centre is 35.0%, the upper limit of the range suggested by bond market investors in discussions, from 37.5% in the first half of FY25. Traders are eagerly hoping for some relief in the Centre's Oct-Mar borrowing plan, with feedback meetings with the central bank currently underway. Dealers expect the government to reduce its supply of long-term gilts in the second half of FY26, but are unsure of which tenure will bear the brunt of the balance supply. 

 

The worst doesn't seem to be over yet for state bonds. The central government's proposal to implement a simplified indirect tax structure may reduce states' revenues, dealers say. Traders expect states' borrowing to increase, to compensate for the revenue shortfall. States agreed to the goods and services tax rate rationalisation despite an expected revenue loss at the Group of Ministers' meeting on Aug. 21. Traders now await the outcome of the meeting chaired by Finance Minister Nirmala Sitharaman this week to ascertain the fiscal slippage. Sakshi Gupta, principal economist at HDFC Bank, says states' gross borrowing for FY26 could be around INR 11.50 trillion to INR 12.00 trillion, from an initial estimate of INR 11.00 trillion at the beginning of the fiscal year. 

 

"Pressure on duration bonds will be there until there's clarity, but the larger brunt will be on state bonds because states are anyway known for their poor management so in the last month of FY we might see state borrowing go up significantly," a dealer at another private sector bank said. "The problem is that anyway for insurers the growth is not much, so demand may not be much, but otherwise too, whatever demand will be there can be seen getting absorbed in the primary gilt auctions since borrowing in long-term gilts is also more. So, market is really unsure on where state bond yields spreads will go to."

End

 

IST, or Indian Standard Time, is five-and-a-half hours ahead of GMT

 

Reported by Cassandra Carvalho

With inputs from Aaryan Khanna and Srijita Bose

Edited by Akul Nishant Akhoury

 

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