Photographer: Dhiraj Singh/Bloomberg

Telling Good From Bad Is Tough for Bond Investors in India

  • State-government bonds offering little differentiation
  • ‘Indebtedness of states is likely to increase’: Crisil’s Gupta

It’s hard to separate winners from losers in India’s burgeoning market for state-government bonds.

A recent debt auction saw West Bengal -- a state struggling to meet its debt obligations -- paying a coupon of 7.64 percent to borrow for 10 years, the same as Haryana -- a northern state that generates most revenue on its own, with limited reliance on federal grants.

The lack of price differentiation and liquidity is reason why global funds such as PineBridge Investments Europe Ltd. have largely stayed away from state bonds despite being granted access to them in 2015. Even so, raising funds isn’t a tall order for states, as the implicit sovereign guarantee of their debt -- besides yields that are typically higher than those on notes issued by the federal government -- means they are a draw for local investors.

“The relatively little yield difference among states isn’t reflective of their fundamentals,” said Anders Faergemann, a senior fund manager in London at PineBridge Investments, which oversees about $83 billion globally. “Bonds of ‘good’ and ‘bad’ states should be priced differently.”

Working together, India’s 29 states combined would form a bloc that has a bigger economy than the whole of sub-Saharan Africa, more members than the European Union, and twice the population of North America.

Net borrowing by regional administrations is set to rise 12 percent to 3.8 trillion rupees ($59 billion) in the financial year starting April 1, after surging an estimated 30 percent to 3.4 trillion rupees this year, according to ICRA Ltd. The central government plans to borrow a net 4.2 trillion rupees in the coming year.

Read: States on Borrowing Binge Bad News for Modi and Indian Bonds

Cutoff yields for states’ 10-year borrowings were bunched up in a tight five-basis point range at an auction on March 27, showing little differentiation between the silk-to sandalwood-producing southern Indian state of Karnataka and the mineral-rich northwestern Rajasthan.

State NameEstimated Fiscal Deficit for FY17 (%)FY18 Estimate (%)Cut-off Yield for 10-Year Debt at March 27 Sale
Andhra Pradesh3.0637.62%
Gujarat1.801.82Didn’t sell
Karnataka2.162.617.59%
Haryana2.492.84*7.64%
Rajasthan6.36*2.997.61%
Tamil Nadu4.58*2.797.62%

Source: State budget documents. *Includes impact from UDAY bonds

Rising supply of state bonds has caused their spread over corresponding sovereign notes to widen to about 90 basis points, from an average 55-60 basis points over the last one year, according to Crisil Ratings Ltd., the local unit of S&P Global Ratings.

Part of the increase has been because some states are acquiring debt piled up at power distribution companies under a 2015 federal plan to revive the utilities. A report by ratings firm ICRA Wednesday showed that 13 states have so far issued 2.32 trillion rupees of the so-called UDAY bonds toward refinancing the borrowings of state-owned electricity retailers.

“The indebtedness of states is likely to increase” going forward due to the takeover of debt under the UDAY scheme, said Manish Gupta, a director at Crisil Ratings in Mumbai. “Higher salary payout and increased interest burden may widen the fiscal deficits over the medium term.”

Thanks to the extra debt burden on account of the UDAY scheme, Rajasthan’s fiscal gap is estimated to have bloated to more than 6 percent of gross domestic product in a financial year ending Friday. That’s double the 3 percent cap set by the finance commission, a panel that decides every five years how tax revenues should be divided between federal and state governments.

West Bengal has been hit by repayment woes and needs to shell out about 470 billion rupees in fiscal 2018 for principal and interest repayments, budget documents show. Tamil Nadu expects a ‘significant impact’ on its resources as the closing down of state-owned liquor shops hurts revenue.

‘Little Incentive’

Markets need to pay greater attention to states’ finances as their widening deficits have completely offset the consolidation at the central level, and borrowings by states is poised to overtake the centre’s by 2018-19, Sajjid Chinoy and Toshi Jain, economists at JPMorgan Chase & Co., wrote in a February report.

Global funds own 15.6 billion rupees worth of state-government bonds, just 7.4 percent of the 210-billion rupee investment limit available to them, according to data from the National Securities Depository Ltd. That’s even as they have exhausted 85.9 percent of their cap for purchases of sovereign debt.

“There is little incentive for investors to discriminate among underlying fiscal positions of states and place a premium on quality,” the JPMorgan economists wrote in their report. “The corollary, of course, is that there is little incentive for states to consolidate, because prudent states are not rewarded and profligate states are not disciplined.”

Boosting Liquidity

That said, Suyash Choudhary, Mumbai-based head of fixed income at IDFC Asset Management Co., says the securities will appear more attractive to investors should authorities improve reissuances to boost liquidity and sell bonds across more maturities.

The Reserve Bank of India typically auctions state bonds once in fortnight. A Finance Ministry report earlier this year said the sale process needs to be reviewed if a ‘modicum of discipline’ is to be introduced on how regional governments’ finances are managed.

“It is a good opportunity to invest in state and corporate bonds now, as their spreads over sovereign notes have backed up quite a bit,” he said.

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