States on Tuesday borrowed Rs 50,505 crore via state development loans (SDL) – their highest borrowing in the current financial year.
After the auction, the spread between the 10-year SDL and the 10-year benchmark 6.79% 2034 bond rose to 53 basis points from 30 basis points.
With an increase in SDL supply, the spread between the two is expected to widen a bit, said market participants. At the auction, the cut-off yield for the 10-year SDL was set at 7.22% and 7.27%, with more than one state borrowing via 10-year bond. SDL yield varies for states based on their demand. The yield on 10-year government securities stood at 6.74%.
The borrowed amount was sharply higher than the notified amount specified in the borrowing calendar of states for the January-March period. As per the calendar, states were to borrow Rs 40,350 crore.
“We expect the supply to increase in coming weeks. This rise is largely driven by increased supply amid high appetite from insurers and EPFO. However, we have to see liquidity conditions. The liquidity in the banking system is in the negative of Rs 1.5-2 trillion, and it is expected to tighten with outflows in the form of advance tax and GST,” said Venkatakrishnan Srinivasan, founder of Rockfort Fincap.
As states tend to borrow more of long-term bonds, insurance companies and pension funds usually step up participation as it helps them manage their asset and liabilities. “Insurance companies must ensure that there is no asset and liability management (ALM) mismatch. SDLs give them a wide variety of long-term bonds, giving them a good opportunity to lock in,” said a trader with a state-owned life insurance company.
In March 2024, states had borrowed heavily owing to a strong need for funds. Though SDL auction usually happens on Tuesdays, they had borrowed twice in a week.
“Similarly, we can expect in-between auctions apart from the regular one that was conducted today (Tuesday),” Srinivasan said.
With the presence of insurance companies and pension funds, increased supply of SDLs is likely to get easily absorbed, said market participants. However, because of tight liquidity conditions, weakness in the local currency and rising uncertainties over US trade policies, there has been an upward pressure on yields. So, the spread between SDL and corporate bonds will also increase.
Globally, the 10-year US Treasury yields has softened, widening the differential between domestic bonds and US Treasuries. Currently, the gap between the two has exceeded 250 basis points. This may influence the movement of foreign flows towards the domestic market. A rise in the yield spread make emerging bond market lucrative to foreign investors.