The pandemic has flattened state and private credit performance

A recent study by CARE Ratings Ltd said that in FY22 so far, state governments have borrowed at a cost similar to that of AAA-rated private sector companies.

“In the current financial year where the average cost of private AAA bonds and SDLs has been as high as 6.84 per cent,” analysts of the firm said in a note.

In essence, a sovereign paper with an implied guarantee pays an interest rate equal to that of a private sector entity for borrowing from the bond market. It may seem counterintuitive, but investors aren’t wrong in asking the states for more.

State development loans (SDLs), or bonds that state governments issue to borrow from the market, are considered sovereign, but are, of course, the central government’s spread on paper.

The 10-year SDL yield is about 60 basis points (bps) higher than the corresponding 10-year government bond, which is no different from pre-pandemic levels. One basis point is one hundredth of a percentage point. The liquidity surplus has grown exponentially since the pandemic. However, surplus liquidity has largely reduced borrowing costs for top-rated private sector issuers. The 10-year AAA-rated corporate bond is priced 65 bps higher than the corresponding 10-year government bond yield. It was 100bps spread over a pre-pandemic, 10 year government paper. The result is that corporate bond yields have crashed after the Reserve Bank of India (RBI) infused liquidity. However, SDLs have rarely been able to achieve these benefits.

Investors want the state to compensate for their financial weakness. The state’s fiscal deficit has increased and so has the state’s borrowing from the bond market since the outbreak of coronavirus. the states borrowed ₹8 trillion in FY21, an increase of 26% over the previous year.

The current fiscal may not be much different as the second wave of the pandemic continues to put pressure on revenues. The state’s finances were affected by the Goods and Services Tax (GST) arrangement with the Center even before the Covid hit. The pandemic has only exacerbated the hit on revenue.

Surplus liquidity is likely to remain stagnant here as RBI may not start liquidity tightening anytime soon. Therefore, for the state’s bond yields to decline, the overall finances of the state would need to improve. The outlook for corporate balance sheets, especially the top rated ones, remains positive. The bond market will continue to favor AAA-rated issuers, while those rated AA and below may struggle.