KEY HIGHLIGHTS

• RBI has helped increase the states' overdraft facility for drawing short-term loans

• Repo rate cut massively by 185 basis points to 4.40 per cent since January last year

• Risk aversion has been on the rise from the days of IL&FS' collapse

• Concerns of mark to market losses if one buys the SDL at current rate

Money chases returns and returns are the function of risk. No, we are not talking about equity markets.  The risk return trade off equally applies for debt market, which offers a fixed interest rates and is perceived to be the safest - but not anymore.  Every  single basis point (one basis point is one hundredth of a per cent) in the interest rates matter for institutional investors like banks, mutual funds, insurance companies and provident funds.

"Investors are now demanding extra yield for no reason. It is probably a bit of risk aversion and storing of cash for better use," explains a fixed income securities dealer. His frustration stems from the fact that the recent primary issuance of states, which are called state development loans (SDL), didn't get the good opening since the entire country is in crisis of sorts. But the investors held their ground and refused to get a lower interest rate.

The state of Kerala has ended up paying as high as 8.0 per cent for 10-12 year SDL issued in April. In fact, the state raised a similar tenor money just a month ago at a much lesser rate of 7 per cent.

Similarly, Uttar Pradesh raised 10 year money under its SDL programme at 7.4 to 7.9 per cent in early March. Surprisingly, the largest state ended up paying 7.10-7.93  per cent for a similar tenor paper in April this month. Other states, too, are struggling to get a better yield on the SDL programmes.

While the RBI has been helping by increasing the states' overdraft facility for drawing short-term loans from the central bank, the advantage of softening of interest rates in the economy is not fully reflected in the state bond yields.

The RBI's move to hike the overdraft facility was aimed at avoiding too many SDL bunching up at the same time to raise money from the market.  In the recent past, the RBI has reduced the repo rate massively by 185 basis points to 4.40 per cent since January last year. In addition, the RBI has flooded the market with liquidity in the last six months. But the transmission of rates is a bit slow in the financial market. Part of the reason could be coronavirus outbreak, which will have far reaching consequences on the corporate sector and states' fiscal position.

Many expert suggest risk aversion in the financial system has been on the rise from the days of IL&FS' collapse. Coronavirus outbreak and the subsequent lockdown has created new risks including impact on state revenues. There are concerns of mark to market losses if one buys the SDL at the current rate as any fiscal slippages would lead to fall in bond prices.  There is a paradox in the market as there are no borrowers for cheap consumer loans, which are linked to repo, even though the coronavirus-impacted sectors like MSMEs, NBFCs ,MFIs and other non-triple A rated companies are gasping for cheaper funds.

The demand for market borrowing is already on the rise. L&T has seen its borrowing cost rising. The engineering giant which is raising resources to create a buffer has been paying close to 8 per cent. There is not much reduction in rates in the market despite surplus liquidity and lower interest rates. Many NBFCs are running around for money in the market with investors asking for higher rates. A well run NBFCs like Mahindra Finance has seen borrowing cost reducing marginally in the last few months. The rural focussed NBFC raised three year NCD issue in February this year at 7.60 per cent. A similar tenor issue by the company had a marginal 10 basis points reduction at 7.50 per cent interest rate.