Why in News?

A sharp increase in borrowing by Indian States is complicating the Reserve Bank of India’s (RBI) ability to bring down interest rates. Despite repo rate cuts, Central government bond yields remain high because heavy State-level debt issuance is distorting the bond market and weakening monetary policy transmission.

Key Facts About Bond Yield

1. Bond Yield

• Bond yield is the return an investor earns from a bond, expressed as a percentage of its current market price.
• It primarily comes from regular interest (coupon) payments.
• It is an important indicator of:
  • Borrowing costs
  • Prevailing interest rates
  • Investor sentiment

2. What is a Bond?

A bond is a debt instrument through which an investor lends money to a government or corporation for a fixed period. The issuer pays:

• Coupons (interest payments) periodically
• Principal on maturity

Factors Affecting Bond Yield

1. Interest Rate Policy

• RBI cuts rates → yields fall
• RBI hikes rates → yields rise

2. Inflation Expectations

• Higher expected inflation → higher yields (to maintain real returns)

3. Government Borrowing

• Larger bond supply → yields rise
  Both the Centre and States heavily borrowing pushes yields upward.

4. Economic Growth Outlook

• Stronger growth → greater credit demand → higher yields

5. Global Factors

• US Treasury yields
• Global liquidity
• FPI flows
• External interest rate movements

6. Credit Risk

Risky issuers must offer higher yields.

7. Yield Curve

• A graph showing yields across maturities.
• Inverted yield curve (long-term < short-term):
  • Often a predictor of recession or slowdown.

8. Bond Yield vs. Bond Price

• Inverse relationship
• Interest rates ↓ → bond prices ↑ → yields ↓
• Interest rates ↑ → bond prices ↓ → yields ↑

Rising State Borrowings and Impact on Bond Yield

1. Scale of Borrowing

For FY 2025–26:

• State gross borrowings: ~₹12.5 trillion
• Centre’s gross borrowings: ~₹14.6 trillion
• Net borrowings:
  • States ~₹9 trillion
  • Centre ~₹10.3 trillion

This marks an unusual situation where State-level borrowing almost matches the Centre’s.

2. Why Investors Prefer State Bonds (SDLs) Over Central G-secs

(a) Quasi-Sovereign Status

• SDLs (State Development Loans) are considered nearly risk-free.
• RBI oversees repayment through statutory mechanisms.
• Default risk is extremely low.

(b) Attractive Yield Spreads

• SDLs offer 80–100 basis points (0.8–1%) higher yield than Central Government Securities.
• Long-term investors (banks, insurers, pension funds) shift towards SDLs.

(c) Market Substitution Effect

• Higher SDL(State Development Loans) yields encourage investors to replace G-secs with SDLs.
• Reduced demand for Central government bonds → G-sec (Government Securities) yields rise.

3. Impact on the Economy

(a) Higher Long-Term Interest Rates

• Rise in bond yields raises long-term borrowing costs for businesses and government.

(b) Steeper Yield Curve

• Short-term rates stay low while long-term yields rise.

(c) Weakened Monetary Transmission

• Even if RBI cuts the repo rate, high bond yields keep borrowing costs elevated.

(d) Fiscal Federalism Challenges

• Excessive State borrowing complicates:
  • National debt management
  • Interest rate stabilization
  • Coordination between Centre and States

Potential Policy Correctives

1. Centre providing more long-term infrastructure loans to States.
2. Allowing States greater access to the small savings fund.
3. Staggering the maturity profiles of State bonds to avoid crowding in particular months.
4. Improving fiscal discipline at State level.
5. Deepening the bond market—including wider investor participation and better liquidity.

UPSC Civil Services Examination, Previous Year Questions (PYQs) 

Prelims

Q. Indian Government bond yields are influenced by which of the following? (2021)

1. Action of the United States Federal Reserve
2. Action of the Reserve Bank OF India
3. Inflation and short-term interest rates

   Select the correct answer using the code given below. 

a) 1 and 2 only 

b) 2 only 

c) 3 only 

d) 1, 2 and 3 

Ans: C

Practice Questions

Q. Which of the following statements correctly describe the relationship between bond prices and bond yields?

1. When market interest rates rise, bond prices fall and yields rise.
2. When market interest rates fall, existing bond prices fall and yields rise.
3. Bond yields serve as a benchmark for interest rates in the economy.

Select the correct answer:
A) 1 and 3 only
B) 2 and 3 only
C) 1, 2 and 3
D) 1 only

Ans: A

Q. Consider the following statements regarding monetary policy transmission in India:

1. When State Governments borrow heavily through SDLs, it can push up yields on Central Government Securities (G-secs).
2. Higher G-sec yields can offset the impact of RBI repo rate cuts on the economy.
3. Monetary policy transmission is affected only by changes in RBI policy rates and not by fiscal actions like government borrowings.

Which of the statements given above is/are correct?
A) 1 and 2 only
B) 2 and 3 only
C) 1 and 3 only
D) 1, 2 and 3

Answer: A) 1 and 2 only