Too Much Paper, Too Little Appetite: State Bond Strains Persist

The long spell of pain in the state bond market has eased, if only slightly. After months of widening, spreads on state development loans have inched lower. The gap between 10-year gilts and comparable state paper narrowed by about 5–7 basis points in the latest auction on Oct 7, helped by smaller issuance sizes. 

Yet the respite is cosmetic, born of supply management rather than any improvement in fiscal or market fundamentals.

What is playing out in the SDL market is a familiar mismatch of too much paper chasing too little appetite. This week’s narrowing is a technical pause, not a turning point.

The June policy review set off a chain reaction across sovereign debt markets. Yields spiked, and SDL spreads more than doubled since April. The 10-year SDL–gilt spread now hovers near 70 basis points, almost twice the long-term average, while 20-year spreads have ballooned from about 10 basis points at the start of 2025-26 to nearly 55 basis points. Even with some bull flattening in recent auctions, sentiment remains thin and cautious.

The problem is straightforward: unrelenting supply. States borrowed ₹5.01 trillion in the first half of 2025-26, nearly 30% higher than last year, with September alone setting a record at ₹1.21 trillion. Emkay Global expects full-year issuances to rise 15–16%. Worse, the average tenor has stretched to around 17 years, compared with a pre-Covid norm of 10. Nearly a third of all bonds now exceed 20 years, a maturity segment even insurers and pension funds are growing reluctant to touch.

In theory, states are mirroring the Centre’s debt-lengthening strategy. In practice, they are adding duration risk and eroding demand. The supply glut reflects deeper fiscal stress: slowing revenue growth and swelling welfare outlays. The GST regime has blunted states’ fiscal autonomy, leaving them dependent on central transfers. Election-linked spending and subsidies have hardened into structural obligations, while tweaks in excise and stamp duties barely move the needle.

Emkay Global says 2024-25 marked the first time since Covid that states slipped on fiscal deficit vs budget estimates, and there is a risk of this continuing in 2025-26 as well, given revenue mobilisation challenges and sticky spending

Demand Fatigue
Investor appetite has faded as well. Banks that had earlier soaked up SDLs are constrained by investment caps and marked-to-market losses. Pension funds are diversifying into equities. With no visible bond purchase support from the RBI or dovish policy signals, the market lacks a stabilising anchor.

Some near-term relief may come from the Centre’s front-loaded tax devolution, giving states space to stagger borrowings. But that is cyclical, not structural.

The fundamentals remain unchanged: rising welfare costs, weak revenue capacity, and a glut of long-dated paper. Unless states commit to credible fiscal correction and the Centre rebalances federal revenues, SDL yields will stay elevated well into next year.

This week’s softening, then, is not the start of a recovery. It is the bond market catching its breath before another climb.