Rising State Borrowings and Their Impact on Bond Yields | 21 Jan 2026

Source: TH 

Why in News?  

A sharp rise in borrowing by Indian States is complicating the Reserve Bank of India’s (RBI) efforts to lower interest rates. Despite repo rate cuts, Central government bond yields remain elevated, as heavy State-level debt issuance is distorting the bond market and weakening monetary transmission. 

What are the Key Facts About the Bond Yield? 

  • Bond Yield: It is the return earned by an investor on a bond, expressed as a percentage of its price, primarily through interest (coupon) payments, and serves as a key indicator of borrowing costs and market interest rates, while also acting as a benchmark for interest rates across the economy. 
    • A bond is a debt security where an investor lends money to an entity (like a government or corporation) for a set period, receiving regular interest payments (coupons) and the principal back at maturity. 
  • Factors Affecting Bond Yield: 
    • Interest Rate Policy: When the RBI cuts policy rates, bond yields generally fall; rate hikes push yields up. 
    • Inflation Expectations: Higher expected inflation leads investors to demand higher yields to protect real returns. 
    • Government Borrowing: Large bond issuances by the Centre or States increase supply, pushing yields upward. 
    • Economic Growth Outlook: Strong growth expectations raise demand for credit, often leading to higher yields. 
    • Global Factors: US Treasury yields, global liquidity, and foreign capital flows influence domestic bond yields. 
    • Credit Risk: Higher perceived risk leads investors to demand higher yields. 
  • Yield Curve: The yield curve is a graph that shows bond yields across different maturities. It indicates the returns investors expect for lending money over various time periods.  
    • An inverted yield curve, where long-term yields fall below short-term yields, is widely seen as a leading indicator of an economic slowdown or recession. 
  • Bond Yield Vs. Bond Price:  Bond prices and bond yields move in an inverse relationship.  
    • While a bond’s coupon rate remains fixed after issuance, market interest rates keep changing. When interest rates fall, new bonds offer lower coupons, making existing higher-coupon bonds more attractive, which raises their prices and lowers yields.  
    • Conversely, when interest rates rise, new bonds offer higher coupons, reducing the attractiveness of existing bonds, causing their prices to fall and yields to increase. 

Rising State Borrowings and Implications on Bond Yield 

  • Scale of Borrowing:  In FY 2025–26, Indian States are set to borrow nearly as much as the Centre, with gross issuances of about Rs 12.5 trillion compared to the Centre’s Rs 14.6 trillion, while net State borrowing (~ Rs 9 trillion) is approaching the Centre’s Rs 10.3 trillion, signalling a major shift in public borrowing patterns. 
  • Investors Preference of State Debt over Central Securities: 
    • Quasi-Sovereign Status: State Development Loans (SDLs) are treated as near-sovereign instruments. Default risk is considered negligible due to statutory repayment mechanisms and oversight by the RBI. 
    • Attractive Yield Spreads: SDLs offer a higher return, with a yield premium of 80–100 basis points over Central Government Securities (G-secs), making them more attractive to long-term investors. 
    • Market Substitution Effect: Banks, insurance companies, and pension funds increasingly substitute G-secs with State bonds to earn higher yields. This reduces demand for sovereign bonds and pushes up Central government bond yields. 
  • Impact on Economy: Raises long-term interest rates and contributes to a steeper yield curve. 
    • Weakens monetary policy transmission, as higher bond yields offset RBI rate cuts. 
    • Creates coordination challenges in fiscal federalism, as rising State borrowings complicate national debt and monetary management. 
  • Potential Policy Correctives: Policy options include higher long-term infrastructure loans from the Centre to States, greater access to the small savings pool, and better staggering of State bond maturities to ease bond market stress. 

Frequently Asked Questions (FAQs) 

1. What is bond yield?
Bond yield is the return earned on a bond, expressed as a percentage of its price, and reflects borrowing costs and market interest rates.

2. Why are bond yields important for the economy?
They act as a benchmark for lending rates, influence investment decisions, and indicate the effectiveness of RBI’s monetary policy.

3. How do State borrowings affect bond yields?
Large State bond issuances increase supply, pushing yields higher and weakening the transmission of RBI’s rate cuts.

4. What is the relationship between bond yield and bond price?
Bond yields and prices move inversely—when prices rise, yields fall, and vice versa.

5. Why do RBI rate cuts sometimes fail to lower bond yields?
High government borrowing, inflation expectations, and global factors can offset the impact of policy rate cuts.

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