From the Opinions Editor: The Indian debt market faces unresolved questions on risk pricing

Understanding Risk Pricing in India's Debt Market

This article discusses critical issues surrounding risk pricing in the Indian debt market, highlighting discrepancies between different segments and raising questions about market efficiency and investor perception.

Background

The Indian debt market is where governments (Centre and States) and corporations borrow money by issuing bonds and other debt instruments. Investors, in turn, lend money by purchasing these instruments, earning interest (yield). The yield reflects the return an investor gets and is influenced by factors like interest rates, inflation expectations, and the borrower's perceived risk.

Over the past year, a peculiar situation has emerged:

1. Short-term interest rates have fallen.
2. Long-term central government bond yields have remained almost flat.
3. Borrowing costs for state governments have risen sharply, making them comparable to AAA rated corporates (companies with the highest creditworthiness).
4. Home-loan borrowers are paying rates only slightly higher than governments, which seems counter-intuitive given the higher risk associated with individual loans.

This suggests that the market might not be accurately pricing the risk associated with different types of debt.

Key Points

1. Divergence in Interest Rate Movements

• Monetary Policy Action: In February 2025, the Reserve Bank of India's (RBI) Monetary Policy Committee (MPC) began cutting interest rates. By the end of 2025, the repo rate (the rate at which RBI lends money to commercial banks) had fallen by 125 basis points (bps), from 6.5 per cent to 5.25 per cent.
• Short-term Rates Reflect Cuts: This reduction was reflected in short-term borrowing rates. The 91-day Treasury Bill (T-bill) yield (a short-term government debt instrument) fell from around 6.54 per cent in January 2025 to 5.28 per cent by February 2026.
• Long-term Rates Remain Elevated: In contrast, long-term rates did not follow this downward trend. The 10-year Government Security (G-Sec) yield (a long-term central government bond) was around 6.7 per cent in January 2025. It declined to 6.16 per cent in May 2025 but subsequently rose, hovering just shy of 6.7 per cent in February 2026.
• RBI Intervention: During this period, the RBI actively intervened in the market through Open Market Operations (OMOs) (buying or selling government securities to manage money supply) to boost liquidity and prevent yields from rising further.

2. Reasons for Steepened Yield Curve and Elevated Long-term G-Sec Yields

The yield curve (a graph plotting yields of bonds with different maturities) has steepened, meaning the difference between short-term and long-term yields has increased. Possible explanations include:

• High Government Borrowing: The Central government has budgeted to borrow a substantial Rs 17.2 lakh crore in 2026-27. This huge supply of government bonds puts upward pressure on yields, as investors demand higher returns to absorb this volume.
• Revenue Concerns: Concerns over the government's future revenues could raise expectations of even higher borrowings, leading investors to demand higher rates as compensation for perceived increased risk.

3. Rising State Government Borrowing Costs

• Hardening Yields: Yields on state bonds (considered quasi-sovereign, meaning they are backed by state governments but carry slightly higher risk than central government bonds) have hardened considerably.
  • For example, the yield on 10-year Gujarat government bonds rose from 7.02 per cent in January 2025 to 7.38 per cent in February 2026.
  • Similarly, Tamil Nadu bonds saw their yield increase from 7.13 per cent to 7.52 per cent during the same period.
• Increased Spread: This surge has increased the spread (the difference in yield) over G-Secs, indicating higher risk perception for state bonds.
• Reasons for State Bond Surge:
  • Sharp Increase in State Borrowings: State government borrowings were estimated at Rs 12.45 lakh crore in 2025-26. While 2026-27 aggregate numbers are not yet available, CareEdge Ratings expects higher redemptions (repayment of principal) to keep borrowings elevated in coming years.
  • Fiscal Stress: Growing concerns over fiscal stress (difficulty in managing finances) among states, partly due to a pivot towards populist policies such as cash transfers, are making markets wary.
  • No RBI OMOs for State Bonds: The RBI's OMOs (which boost liquidity) do not involve state bonds. This means state borrowing costs are more directly determined by market supply-demand dynamics, which can lead to higher yields when supply is high.
• Comparison with Corporates: State bond yields are now comparable to corporate bonds. In January 2025, the AAA 10-year corporate bond yield was around 7.44 per cent, averaging roughly 7.48 per cent in February 2026 (Data source: ICRA). This raises a critical question about credit risk premium.

4. The Disappearing Credit Risk Premium?

• Credit Risk Premium Defined: This is the additional yield investors demand for holding non-sovereign bonds (like corporate or state bonds) where there is a possibility of default, compared to a risk-free asset (like central government bonds).
• Market Anomaly: The fact that state bond yields are now similar to AAA rated corporate bonds suggests that the market might be considering them equally risky, or perhaps even considering corporate bonds as safe as state debt.
• Home Loan Anomaly: The interest rate on home loans for high-quality borrowers is only slightly higher than government bonds (e.g., a 20-year UP bond yield is just under 7.70 per cent). This implies that banks are not charging a significant spread for lending to individual borrowers, despite these being less liquid securities with a higher probability of default (even with collateral).

5. Unresolved Questions

The market signals are ambiguous:

• Has the risk perception of state bonds increased, while that of private entities (corporates, individuals) declined?
• Is this simply a matter of liquidity and differentiated markets (where different segments behave differently)?
• Or, is risk being mispriced at the long end of the yield curve and/or at the credit level across various debt instruments?

Exam Relevance

This article is highly relevant for UPSC Civil Services Exam, particularly for General Studies Paper 3 (GS3).

• GS Paper 3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

  • Monetary Policy: Role of RBI, MPC, repo rate, OMOs, and their impact on interest rates and liquidity.
  • Fiscal Policy: Government borrowing (Centre and States), fiscal deficit, revenue concerns, and their implications for the debt market.
  • Financial Markets: Functioning of the debt market, bond yields, yield curve, T-bills, G-Secs, corporate bonds, and home loans.
  • Public Finance: Challenges in managing government finances, especially fiscal stress at the state level due to increased borrowings and populist policies.
  • Mobilization of Resources: How governments raise funds and the cost associated with it.

• Likely Question Angles:

  1. "Discuss the factors contributing to the divergence in short-term and long-term interest rates in India's debt market. What are its implications for economic growth and investment?" (Focus on MPC, RBI OMOs, government borrowing).
  2. "Analyze the reasons behind the rising borrowing costs for state governments in India. How do populist policies contribute to fiscal stress, and what measures can be taken to ensure fiscal sustainability?" (Focus on state borrowings, fiscal stress, populist policies, RBI OMOs exclusion).
  3. "What is 'credit risk premium'? Examine whether the Indian debt market is accurately pricing risk, particularly in the context of state bonds, corporate bonds, and retail loans." (Focus on credit risk premium, comparison of yields, market anomalies).
  4. "Explain the concept of the 'yield curve' and how its steepening can signal underlying economic concerns. What role does government borrowing play in shaping the yield curve?" (Focus on yield curve, government borrowing, revenue concerns).
  5. "Critically evaluate the effectiveness of RBI's Open Market Operations (OMOs) in managing liquidity and controlling bond yields, especially considering their limited scope for state bonds." (Focus on OMOs, liquidity, limitations).