Banks want steps to increase liquidity in state govt bonds

Buy back of bonds, papers with varying maturity proposed

To broaden investor interest in state government bonds, banks have suggested issuance with varying maturities rather than only 10-year papers. Banks, major investors in such bonds, have also proposed that state governments buy back some old papers and re-issue under the borrowing programme to increase liquidity.

The Reserve Bank of India (RBI) has begun consultations with state governments and investors to understand the concerns and facilitate the process for improving liquidity.

According to senior public sector bank executives who attended a meeting in this month in New Delhi, two issues were in focus. One, the ways to attract more investors to trade in state paper and improve liquidity. Two, the issue of states having to pay a premium (offer a higher coupon rate) on their paper over central government bonds.

These securities, issued by state governments, are also known as state development loans (SDLs). The issues are managed and serviced by RBI.

According to CRISIL’s annual book on the Indian bond market, 2014, state government bond issuances grew 17 per cent in 2013-14 to touch Rs 2 lakh-crore for the first time, largely in line with the growth in gross state domestic product. Low liquidity is the nature of the market, with investors such as provident funds and insurance companies preferring to hold bonds till the maturity. These investors look for a safe investment with steady stream of income and are not keen in trading in these.

Making bonds liquid
According to bank treasury executives and mutual fund executives, as a step to improve liquidity, states could issue bonds with varying maturities such as five years and even long-duration paper of 15 years. This would help develop the yield curve.

At present, states continue to borrow a majority of funds through 10-year bonds. Borrowings of up to five-year maturity, introduced in FY13, has a minuscule share.

Akhil Mittal, senior fund manager (fixed income) at Tata Asset Management, said the introduction of SDLs of lower tenure (three years or five years) could lead to higher allocation to SDLs in mutual funds as liquidity would improve.

There is enough appetite for SDLs, but the allocation to SDLs compared to government securities is much lower in mutual funds, Mittal said.

Going forward, there might be demand for state papers among urban cooperative banks and the upcoming payments banks.

Also, state governments can buy back bonds which were issued earlier. This would create liquidity (market-based sale and purchase transactions) in otherwise illiquid instruments.

An IDBI Bank executive said for buying back, states can set aside, say, Rs 500 crore out of Rs 10,000 crore raised from the market.

Parity with govt bonds
Another question at the meeting was the higher yields the market expects state governments to pay for bonds over the 10-year tenure issued by the central government.

In the latest round of state bond auctions, on January 27, the cut-off yield on 10-year SDL was in the range of 8.5 per cent. On the same day, the yield on a 10-year benchmark bond was 7.7 per cent.

Those representing states showed displeasure over the premium that states have to pay over Government of India bonds.

According to a senior state government official who attended the meeting, states have a better record on fiscal indicators than the Centre. Unlike Government of India bonds, securities issued by states are not treated as sovereign paper.

The head of treasury with an associate bank of State Bank of India said states often feel they end up paying a premium (higher yield) due to higher perceived risks such as reservations over debt repayment ability. Till date, no state government has defaulted on payment of interest or principal.

Treasury executives explained the higher yield captures illiquidity in these instruments. Secondary market activities in the previously-issued securities are very poor, but the recently issued securities are most traded instruments, according to Clearing Corporation of India Ltd.