India's bond rally at risk as govt, states gear up for big debt sales

A rally in India's bond market this month could prove short-lived as investors brace for as much as $157 billion in sovereign debt sales over the next year, including from states financing a big bailout of electricity utilities, analysts warn.

The amount of supply expected will be well above the $130 billion raised this fiscal year ending on March 31, and could push yields higher as investors demand higher interest rates to finance the supply starting next month.

Although the government pledged in February to keep its fiscal deficit at 3.5 percent of gross domestic product for 2016/17, that does not include states' rising borrowing needs.

Nor does it include the costs of Prime Minister Narendra Modi's plan to push regional governments into assuming 4.3 trillion rupees ($64.49 billion) in debt owed by their utilities.

Most of that debt will be taken over by banks, and hence kept out of the markets, but the so-called UDAY scheme to revive India's loss-making power distribution companies still involves around 1 trillion rupees in additional borrowing by states.

"With more supply expected, I expect the spillover impact to push up long-term central government bond yields," cautioned Ashish Vaidya, head of trading and asset liability management, at DBS Bank in Mumbai.

Huge supply could overturn a bond rally that began on Feb. 29 when the government made its fiscal pledge. Benchmark 10-year yields have eased 12 basis points (bps) since then.

Easing inflation has added to the gains, raising hopes the Reserve Bank of India could cut interest rates by as much as 50 bps at its next policy review on April 5.

But that rally has ignored the looming supply: India's government and its 29 states are expected to issue 9.5 trillion rupees in bonds, including 6 trillion rupees by the central government over the next year, a 9 percent increase from this year.

On top of that, states and their utilities are also set to sell around 1 trillion rupees in bonds tied to the UDAY scheme, putting the potential supply next year at 10.5 trillion rupees ($157.47 billion).

Analysts believe the supply will be absorbed, given banks have hefty reserve requirements that mandates them to buy sovereign securities.

But it will be at a cost. Besides banks and government-run agencies such as Life Insurance Corp (LIC), the investor base remains limited, giving buyers more power to demand higher yields.

"LIC has a finite book. As we go into the new financial year and supply starts, I would expect yields to harden," said Pradeep Madhav, managing director, STCI Primary Dealer Ltd.