State governments that were dealing with a peculiar and unsettling trend — of having to borrow funds at steep interest rates about two months ago —have a lot to cheer.

In the recent auctions, many State governments have been able to raise funds at very low interest rates. The rates on shorter tenure 3-5 year State development loans (SDLs) in particular have been very attractive, given the strong demand for these bonds.

Sample this. In the recently concluded auction (June 23), three-year SDLs of Maharashtra were auctioned at a cut-off yield of 4.76 per cent and two-year SDLs of the State were auctioned at around 4.5 per cent (in the beginning of June). The State government has also been able to raise funds for the longer term at much cheaper rates than in April, when yields had spiked. Over the recent weeks, 10-11 year SDLs of Maharashtra were auctioned at around 6.6 per cent, far lower than the 7.7-7.8 per cent yields on such bonds auctioned in April.

Similarly, Tamil Nadu that had raised funds through its 9-10 year bonds in April at a steep 7.5-7.7 per cent has been able to raise similar funds at 6.5-6.6 per cent in the past few weeks. It also managed to raise cheap short-term funds — two-year SDLs at 4.5 per cent in the beginning of June.

Kerala’s 15-year SDL was auctioned at a whopping 8.96 per cent in April. Interest rates on such long-tenure bonds have fallen sharply in recent weeks — 8-10 year SDLs auctioned at a cut-off yield of 6.5-6.7 per cent. Rajasthan, too, has seen rates on its SDLs fall substantially — 6.5 per cent on its 10-year bond.

 

Tables turn

In April, just after the RBI had announced its so-called ‘bazooka’ measures — slashing the policy repo rate, cutting cash reserve ratio, and announcing targeted long term repo of ₹1-lakh crore — the yield on government bonds and SDLs had uncannily shot up.

This was due to various factors. One, the market was concerned over the supply of government bonds, owing to rising fiscal deficit. Two, demand from foreign investors was weak. Three, and importantly, domestic banks had turned wary of investing even in safe government bonds fearing MTM (mark-to-market) loss owing to possible rise in yields.

So what has changed over the past two months? Additional borrowings by the Centre and States over the coming months continue to remain a worry. Also demand from foreign investors remains tepid. FPIs have pulled out over ₹1-lakh crore from Indian debt so far and are utilising just 29 per cent of their limits (only 1 per cent in SDLs).

Domestic banks’ demand

But what has changed the fortunes of the government and SDL market is the rising demand from domestic banks in the primary market over the past month. This has mainly been driven by sudden pick-up in deposit growth amid weak credit growth.

From 8-9 per cent in March and April, deposit growth has risen to about 11 per cent in June, even as credit growth continues to languish at 6 per cent levels. Banks that have been sitting with excess liquidity over the past few months, have more funds to deploy now. But persisting risk aversion to lending has nudged banks to continue to park funds under reverse repo window (despite very low returns of 3.35 per cent). In June, banks have parked over ₹6-lakh crore under reverse repo on a daily average basis.

That aside, banks have started to participate in the primary market of government bonds, too. With the overnight rate at 3.5 per cent and some of the short-term SDLs fetching 4.5-5.5 per cent, banks are able to make a clear spread of 150-220 bps by investing in such safe assets.

While concerns over treasury/MTM loss remain, banks are mitigating the duration/interest rate risk by participating actively in the shorter tenure bonds, which is where yields are plummeting significantly.

Demand for very long tenure 30-year SDLs has also been buoyant. Rajasthan and Tamil Nadu’s 30-year SDL was auctioned at 6.7 per cent in the recent auction, even as 10-year bonds of these states fetch almost similar yields of 6.5-6.6 per cent.

 

Published on June 24, 2020