Consider the scenario. Over the past year, while short-term interest rates have fallen, long-term central government bond yields have been almost flat. In contrast, borrowing costs for states have risen sharply. State governments are now, in fact, paying as much as AAA rated corporates. This, however, isn’t the only quirk. Home-loan borrowers are barely paying a higher rate than governments. Something seems amiss.AdvertisementLet’s take a step back. In February 2025, the RBI’s monetary policy committee began to cut interest rates. By the end of the year, the repo rate had fallen by 125 basis points – from 6.5 per cent to 5.25 per cent. This reflects in the shorter term borrowing rates. In January 2025, just before the MPC cut rates, the 91 day Tbill yield was hovering around 6.54 per cent. By February this year, it had fallen to 5.28 per cent.Long-term rates have, however, remained elevated. The 10 year GSec yield which was around 6.7 per cent in January last year, and had declined to 6.16 per cent in May, rose thereafter. In February this year, yields have been hovering just shy of 6.7 per cent. This period has also seen the central bank actively intervening in the market through open-market operations to boost liquidity and prevent yields from hardening further.There are several possible explanations why the yield curve has steepened. The huge supply of government paper – the Centre has already budgeted to borrow Rs 17.2 lakh crore in 2026-27 – is putting upward pressure on yields. There may also be concerns over the government’s revenues which could have raised expectations of higher borrowings. Investors are thus demanding higher rates as compensation.AdvertisementIn comparison, yields on state bonds, which are considered quasi-sovereign, have hardened considerably. For instance, between January 2025 and February 2026, the yield on 10-year Gujarat government bonds has risen from 7.02 per cent to 7.38 per cent, while that on Tamil Nadu bonds has risen from 7.13 per cent to 7.52 per cent.This surge – which raises the spread over Gsecs – could be due to many reasons. One, the sharp increase in state borrowings which comes amidst growing concerns over fiscal stress as several governments pivot towards populist policies such as cash transfers. In 2025-26, state-government borrowings have been estimated at Rs 12.45 lakh crore. While the aggregate number for 2026-27 is not yet available — several states are yet to present their budgets — higher redemptions are expected to keep borrowings elevated over the coming years as per CareEdge Ratings. Markets are therefore worried about absorbing this increase in state paper. Moreover, the RBI’s open-market operations do not involve state bonds. And liquidity does matter. Though perhaps this does suggest that state borrowing costs are more market determined and better reflect the supply-demand dynamics.But, this has meant that state bond yields are now comparable to corporate bonds. In January 2025, the AAA 10-year corporate bond yield was hovering around 7.44 per cent. A year later, in February, it is averaging roughly 7.48 per cent (Data source: ICRA). This raises the question: Has the credit risk premium – the additional yield that investors demand for holding non-sovereign bonds where there is the possibility of default – disappeared? To put it differently, is the market now considering corporate bonds as safe as state debt?That is not all. The interest rate on home loans for high quality borrowers is only slightly higher than that of government bonds – the yield on a 20-year UP bond is just under 7.70 per cent. What this essentially means is that banks are not charging a sizeable spread for lending to individual borrowers. In other words, they are not demanding higher returns for holding a less liquid security – although with collateral — but one which should have a higher probability of default.So what is the market signalling? Has the risk perception of state bonds increased while that of private entities declined? Or, is it a matter of liquidity and differentiated markets? Or, is risk being mispriced at the long end of the yield curve and/or at the credit level?Till next time,Ishan BakshiRecommended Readings:Pratap Bhanu Mehta writes: From a book on authoritarianism, lessons on ‘realism’ for IndiaSwapna Liddle writes: Edwin Lutyens paid homage to India’s history and architectural traditionsyou may likeVamsee Juluri writes: Beyond Lutyens and C Rajagopalachari, the harshest legacy is our mental self-colonisationRoopali Sinha writes: In metros and beyond, where we need to ‘mind the gap’ — and where we don’tSanjay Srivastava writes: Bihar’s meat ban, Deputy CM’s statements, and a question: Are vegetarians inherently peaceful?