State bond yields outpace AAA rated corporate bond yields for long tenors

State bond yields have been trading higher than AAA-rated public sector undertaking (PSU) bonds for maturities of 10 years and beyond, data showed.

 

Recent state development loans (SDL) auctions have shown average yields of around 7.11 per cent for longer tenors, climbing to 7.23 per cent in annualised terms.

 

On the other hand, AAA-rated PSU bond yields for similar maturities are trading slightly lower, between 7.10 per cent and 7.16 per cent.

 

Market participants said that the price difference is largely driven by heavy supply, timing mismatches in fund flows, and rising global interest rates.

 

“This yield differential is influenced by a combination of increased supply, investment behaviour driven by regulatory mandates, and broader macroeconomic factors,” said Venkatakrishnan Srinivasan, founder and managing partner of Rockfort Fincap LLP.

 

“Following the Federal Open Market Committee’s (FOMC’s) hawkish commentary alongside a 25 basis points (bps) rate cut, global yields, including US Treasuries, have risen, causing an upward adjustment in Indian bond yields,” he added.

 

Bond yields surged post the US Federal Reserve meeting outcome as the Fed indicated towards a more measured pace for future reductions. This has triggered uncertainty across financial markets, said dealers.

 

The US rate setting panel cut the interest rates by 25 bps bringing down the Fed Funds rate to 4.25 per cent-4.5 per cent. This has spilled over to the Indian bond market, causing yields across instruments, including SDLs and PSU bonds, to rise by 4–5 basis points for tenors of 10 to 15 years.

 

Additionally, the Fed’s latest dot plot revealed a significantly more hawkish stance, with only two rate cuts projected for 2025 — half the number anticipated in September — and just two additional cuts expected in 2026, against the previous expectation of four rate cuts.

 

SDLs, issued by state governments and managed by the Reserve Bank of India (RBI), are traditionally considered nearly as safe as government securities (G-Secs).

 

“This has happened before where SDL yields have traded higher than corporate bonds. It is mainly because of an increase in supply and also the demand for AAA-rated bonds is significant. The yield also depends on outlier states where the amount of freebies and the supply of bonds are comparatively higher,” said the treasury head at a private bank.

 

Market participants said that seasonal factors are also at play. Provident and pension funds, which see inflows from contributions and interest payments in December and January, typically prioritise AAA-rated PSU bonds early in the fiscal cycle.

 

These bonds offer liquidity and align well with their portfolio mandates.

 

However, SDLs remain a favourite for long-term investors like pension funds and insurers. This is especially for those looking to lock in higher returns ahead of an expected rate-cutting cycle starting in February. Adding to the pressure is a liquidity crunch in the banking system.

 

SDL issuances, concentrated in the second half of the financial year, have coincided with rising US Treasury yields and a weakening rupee, which recently breached Rs 85 a dollar. These factors have tightened domestic monetary conditions, pushing yields higher across the board.

 

Despite these challenges, SDLs continue to attract strong interest from institutional investors, who view them as a low-risk option with attractive returns.

 

The higher yields on SDLs compared to AAA PSU bonds reflect market dynamics like supply-demand imbalances rather than an increase in perceived risk.

 

As the financial year wraps up, SDL yields are expected to stay elevated, shaped by ongoing supply adjustments and market anticipation of domestic and global policy changes.

 

Once the current wave of issuances is absorbed and the expected rate cuts begin, yields are likely to stabilise.

 

For now, SDLs remain a cornerstone of institutional portfolios, offering reliable returns in an evolving bond market landscape. 

Key Insights

-  Market participants said the difference is driven by heavy supply, timing mismatches in fund flows, and rising global interest rates

  -  Dealers said the bond yields surged post the US Fed meeting outcome as it indicated towards a more measured pace for future reductions

  -  SDL yields to stay elevated due to ongoing supply adjustments and market anticipation of domestic and global policy changes