What determines yields of India’s State government bonds?

A trio of RBI econs write this nice paper on the topic.

India has developed its State government bond market (nicely called as State Development Loans) and now states also meet their deficits via this bond market system like the central government. This state governments started issuing bonds through auctions in 2006-07.  There is some nice history to the overall developments in state bond markets:

Till 1998, the Reserve Bank used to complete the combined open market borrowings of all the States generally in two or more tranches through issuance of SDLs with a pre-determined coupon and notified amounts for each State. In 1998-99, States were allowed to enter the market individually to raise resources using the auction method or tap method (with pre-determined coupons but without pre-determined notified amounts) with a view to providing scope of accessing funds at market rates for better managed States. The auction method could be used to the extent of 5 to 35 per cent of the allocated market borrowings (subsequently raised to 50 per cent), at the discretion of the State. To avoid the risk of under-subscription, the Umbrella Tap Tranche method was introduced during 2001-02. Under this method, after receiving the concurrence of States, the Reserve Bank used to indicate the names of States participating in the tap, the aggregate targeted amount to be raised and the coupon – the latter uniformly fixed for all the States. The targeted amounts in respect of individual States were not separately announced. Up to December 2002, the tap used to be normally kept open till the targeted amount was received for each State. In January 2003, it was decided to close the tap at the end of the second day even if the targeted amount was not mobilised (Annex I).

Until 2001, under the traditional tranche method, pre-announced coupon was normally fixed at around 25 basis points (bps) over and above the Government of India (GoI) securities of corresponding tenor. However, as interest rates fell sharply in 2000-01, and yield differences started emerging between liquid and illiquid GoI papers, it became difficult to complete the market borrowing programme (MBP) of the States at these spreads. From 2001, such spreads increased to around 50 bps. However, the system of a fixed uniform coupon did not provide any cost advantage to fiscally better managed States. Therefore, States were encouraged to move to the auction system in a gradual manner, based on the premise that competitive coupons could emerge in a market-oriented system. Notwithstanding the introduction of the auction system for SDLs in 1997, the complete switch-over to this system for raising market borrowings has taken place only from 2006-07 onwards.

With the auction-based issuances of SDLs, the yield spreads have since become variable, and exhibit differences across the States, which could be attributed to market and fiscal conditions.  During 2006-07, the spreads on SDLs (in the primary auction) ranged between 27-56 bps over and above the secondary market yield on GoI securities of corresponding tenor.

So, this paper looks at two broad qs:

  • What is the spread between Centre and State Govt bonds?
  • What determines movement in state bond yields?

For first q the spread varies depending on the business cycle and conditions:

  • In 2008-09 average spread was 122 bps (range of 21-236 bps). amount raised 118,138 Cr
  • In 2009-10 avg spread is 86 bps  (range 45-129) amount raised 1,31,122 Cr
  • In 2010-11 avg spread is 45 bps amount raised – 104039 Cr

Overall, the yields on SDLs reflect the general interest rate regime and the spread varies depending on a host of factors including the monetary policy initiatives from time to time. During the initial phase, which was characerised by higher interest rates, the spread was moderate (Chart 2). However, despite the general interest rate regime easing thereafter, the spread settled at a higher level. During the recent period, the call rates have firmed up significantly but the bond yields have not firmed up noticeably except on a few occasions. The pattern of past auctions shows that accessing the market at a right time with right size of issuance yields a right price to the SDLs, with a narrowing down of the spread.

 On what leads to movements in these bonds. Results are surprising:

the key deficit indicators which are generally monitored to gauge the fiscal performance do not seem to explain the yield spreads across States. The analysis lends some support to the argument that the States with higher debts pay higher yields as compared with other States. Similarly, there is also evidence that Central transfers to the States help them to raise borrowings at lower spreads. Notwithstanding the low explanatory power of fiscal variables in variation in yield spreads, the importance of rule-based fiscal policy during the period of our analysis cannot be undermined.

In fact, the fiscal consolidation being pursued by the States might have provided confidence to the market whereby temporary deviations in deficit levels observed during crisis years were expected to be corrected over the medium-term. Furthermore, it needs to be noted that fiscal discipline at the State level is progressively becoming incentivised by the Finance Commissions, which may have acted a source of comfort for the market. It is corroborated by the fact that after witnessing fiscal stress during the period of global financial crisis, most States seem to have reverted to path of fiscal consolidation as evident from lower deficit ratios during 2010-11 and 2011-12.

Hmmm..Actually I did post on something similar related to West Bengal state bonds. The markets were not pricing the risk of state government despite Singur mess.

But overall this is pretty standard stuff. Most yields f state auctions are around the same levels on a given day. So say, UP, Bihar, Tamil Nadu and Maharashtra issue bonds on one day. You get near similar yields for the states with a few bps here and there. It gives you a feeling as all states are similar in terms of business and finances. Which is not true of course.

It is like EMU before the crisis where markets traded a Greece bond similar to a German one despite stark differences in their economies.

Now I am not suggesting we are headed EMU way. Not at all. Just that markets should price state bonds properly so that states can be differentiated and reform accordingly…

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