More supply at longer end, GST-cut proposal keep bond yields elevated

Yields on state government bonds also hardened sharply. The 10-year SDL yield, which was in the range of 6.84-6.88 per cent in the first week of April, has climbed to 7.09-7.17 per cent as of Aug 19

On Friday, a large non-banking financial company which is in the upper layer of the Reserve Bank of India’s scale-based supervision list, postponed its bond issuance due to lack of investor appetite as yields stayed elevated. A 15-year government security, introduced in early July, saw yields surging 25 (basis points) bps in a very short span. 

Yields on state government bonds also hardened sharply. The 10-year SDL yield, which was in the range of 6.84–6.88 per cent in the first week of April, has climbed to 7.09-7.17 per cent as of August 19. The rise has been even sharper at the longer end, with yield on 30-year SDLs moving from around 6.87 per cent in early April to about 7.44 per cent in August. 

Bond yields have surged across the board despite a 100 bps reduction in the policy repo rate since February which included a front loaded rate cut of 50 bps in the June review of the monetary policy. 

A combination of factors — over supply of long duration bonds, fading hope of further easing of policy rates, recent proposal of cut in GST rates, and short position by investors, has resulted in reversing monetary transmission in the bond market. “The corporate bond market, the state bonds have become completely illiquid. If someone wants to sell, then they have to take a short position in the 10 year benchmark government bond, which further pushes up yields,” said a trader from a large commercial bank. 

According to market participants, FY26 saw significant rise in average tenor of state government borrowings, resulting in demand supply mismatch. Telangana, Kerala, West Bengal, Punjab, Maharashtra, Madhya Pradesh, Rajasthan and Bihar have sharply shifted the issuance tenor higher. So far in the current financial year, states’ borrowing has risen by 31 per cent year on year. “Higher SDL supply both in quantum and tenor, comes in the backdrop of deteriorating public finances, with the States’ FY26 FD/GDP budgeted to be higher than 3% — third year in a row,” said economists at Kotak Mahindra Bank in a report. 

Long tenure bonds typically get interest from pension funds and life insurers. A change in norms allowing pension funds to invest 25 per cent in equities as compared to 15 per cent earlier, meant a significant part of incremental funds are allocated for equities. In addition, life insurance companies are also putting more money in equities due to better returns. 

With government bonds yields surging, banks are parking their excess funds in the variable rate repo auctions. “Banks are preferring parking short-term surplus funds in instruments like VRRR, CDs, or CPs rather than government securities, since G-Secs are more suitable for medium- to long-term investments or trading positions,” said V R C Reddy, head of treasury at Karur Vysya Bank. 

“Investment in G-Secs has slowed because the market believes policy rates have already peaked, around 5.5 per cent, and no further easing is expected,” he said. 

After cutting the policy repo rate by 100 bps between February and June, the rate setting panel of RBI changed the stance to neutral in June. In the August review of monetary policy, rates were kept unchanged. “Taking into account the growth-inflation outlook, past actions, the state of the domestic economy, and the global dynamics, I do not see the scope or rationale for a further policy rate cut at this point,” RBI’s deputy governor in-charge of monetary policy Poonam Gupta said, the minutes of the August meeting showed. 

The other reason for banks’ aversion to sovereign papers is the new investment norms of RBI which came into effect from April 1, 2024. The new norms mandated if securities are held in the trading book, mark-to-market gains or losses to be taken through the profit and loss account. 

“With no signs of easing, banks are cautious about taking fresh positions in trading portfolios. Also, PSU banks already hold about 28-29 per cent in SLR securities. With limits reached, there’s a visible shift toward non-SLR instruments like CPs and NCDs for yield optimisation,” Reddy added. 

PM Narendra Modi’s announcement on 15 August that the government is planning to rationalise GST rates spooked the bond market further over concerns over fiscal slippages. GST rate cut announcement completely wiped out bond gains due to the sovereign rating upgrade by S&P. “The rise in yields was broken by the surprise sovereign upgrade from S&P, only to be neutralised the very next trading day by fiscal fears on account of proposed GST rate rationalisation,” said Suyash Choudhary, Head – Fixed Income, Bandhan AMC. “The proposed GST rate rationalisation broadly equates to 50 bps total annual fiscal impact borne 1/3rd and 2/3rd by centre and states respectively. However, impact for FY26 will be half that since implementation will be for half year only,” Choudhary said. 

 The central bank has been keen to ensure fast and effective monetary transmission through lending and deposits rates. In the credit market, the weighted average lending rate (WALR) of scheduled commercial banks declined by 71 basis points for fresh rupee loans and 39 basis points for outstanding rupee loans from February 2025 to June 2025. On deposit side, the weighted average domestic term deposit rate (WADTDR) on fresh deposits moderated 87 bps during  same period. 

While monetary transmission via credit markets has been impactful, the same is not true for the bond market, where there is actually a reverse transmission. With RBI projecting headline inflation – the main yardstick for policy making – above 4 per cent for the Jan-March quarter of FY26 and close to 5 per cent for the first quarter of the next financial year, indicating low chances of monetary easing, bond yields are likely to stay elevated for long.