PSBs raise investment limit in state bonds to capitalise on higher yields

Public sector banks increase SDL allocation to 40-50% of HQLA portfolios, drawn by higher yields and widening spreads over central government bonds

State-owned banks have increased their investments in State Development Loans (SDLs) to capitalise on the higher yields these securities offer compared with central government and corporate bonds in the current financial year. Bond prices and yields are inversely related.

 

Market sources said public sector banks have allocated about 40 per cent–50 per cent of their high-quality liquid assets (HQLA) portfolio to SDLs, drawn by attractive returns and a widening yield spread of up to 80 basis points over central government bonds in the July-September quarter.

 

In comparison, private banks’ allocation to SDLs was estimated at around 35 per cent. Several SDL auctions were undersubscribed in the second quarter of the current financial year, with yields inching up by 50 basis points to 60 basis points.

   

In the last financial year, government banks allocated about 20-25 per cent of HQLA on state papers.

 

“Given the spread, PSU banks have allocated 40 per cent to 50 per cent of their HQLA to SDLs. While private banks’ allocation is around 30 per cent – 35 per cent,” said the treasury head at a private bank. 

 

“The spread (yield spread between SDLs and government bonds) will remain elevated until non-bank entities allocate more to SDLs,” he added.

 

Market participants said that with few high-yield options and limited credit growth, PSBs are increasingly using SDLs to park surplus funds.

 

“Many large PSU banks have increased their internal investment limits in SDLs by 20-25 percentage points,” said a market participant. “The banks are parking surplus funds in SDLs, because the credit growth is limited. The yields on SDLs have gone up significantly because there is lack of participation from pension funds and insurance companies, while supply is high,” the person added.

 

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.

 

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.