Unlocking Tactical Opportunities in a Dislocated Bond Market

Synopsis

Despite a supportive macroeconomic backdrop-including rate cuts, improved sovereign ratings, and subdued inflation-India's bond markets have experienced notable dislocation. Yields have risen sharply across the curve, with longduration government bonds bearing the brunt. This divergence stems from structural imbalances, evolving fiscal expectations, and shifting regulatory dynamics. As outlined in previous Acumen insights, these developments have steepened the yield curve and created tactical entry points for investors. This note explores the drivers of recent volatility and highlights short-term opportunities (rally of 15-25 bps) in long-duration bonds.

The backdrop

India's bond markets have experienced notable volatility in recent months, despite a series of positive macroeconomic developments. The Reserve Bank of India (RBI) implemented a 50 basis point (bps) policy rate cut in June 2025, followed by a 100 bps reduction in the Cash Reserve Ratio (CRR). Additionally, S&P upgraded India's sovereign rating to BBB from BBB-, and headline inflation reached an eight-year low of ~1.55%. Yet, bond yields have risen by 30-50 bps across the curve, with long-duration government bonds experiencing a pronounced impact.

Key drivers behind the recent rise in bond yields

As previously highlighted in our Acumen - Can Surplus Banking Liquidity lead to a steeper yield curve and Is the rally over in Long Duration Bonds, several structural and policy driven factors have contributed to the steepening of the yield curve and the relative underperformance of long duration bonds vs short duration.

1. Liquidity Surplus and End of Rate Cut Cycle: Excess liquidity in the banking system, coupled with the conclusion of the rate easing cycle, has led to a steeper yield curve.


2. Demand-Supply Imbalance: A significant shortfall in demand-exceeding Rs 1 trillion-for central and state government bonds, particularly at the longer end of the curve, has exerted upward pressure on yields.


3. Fiscal Policy Shift: The anticipated pivot from fiscal consolidation to thrust on fiscal tools aimed at stimulating growth has raised concerns about increased government borrowing.

Market Dislocation: Key Catalysts

The bond market has witnessed a sharp sell-off over the past three months, driven by a confluence of unexpected developments:

• Unexpected RBI Stance: Following the front-loaded rate cut in June, the RBI's subsequent stance and actions have signaled a more cautious approach, dampening expectations of further easing.


• Reduced OMO Expectations: The 100 bps cut in CRR significantly diminished the likelihood of the RBI conducting Open Market Operations (OMOs) to purchase bonds, removing a key source of demand and contributing to rising
yields.

Market Dislocation: Key Catalysts (Contd.)

• Fiscal Worries: An expected cut in the Goods and Services Tax (GST) could strain the government's fiscal balance, potentially leading to higher borrowing in the future. This expectation of increased debt supply also pushed yields higher.


• Regulatory Changes: Changes in investment norms for pension funds and banks' Held-to-Maturity (HTM) guidelines have curtailed institutional appetite for long-duration bonds. Simultaneously, a higher supply of State Development Loans (SDLs) has further flooded the market.

Impact on Bond Market Yields

Source: Bloomberg

Recent data as seen in the table indicates that long-term government bond yields have reverted to levels seen prior to the commencement of the rate cut cycle in February 2025. This pronounced steepening of the yield curve highlights the extent of dislocation currently impacting the bond market.

Impact on Bond Market Yields

The recent sell-off has caused a dislocation in the bond market, where short-term bonds have outperformed long-term ones. However, this has also created tactical opportunities for informed investors.

• Attractive Entry Points: The sell-off has pushed bond yields, particularly for government bonds, back to levels seen before the recent rate-cut cycle began. This offers a more attractive entry point for investors.


• Scope for a near term rally: There's a possibility of a 15-25 bps rally in long duration bonds in the near term. This could be triggered by several factors, including:


• Growth headwinds: Any additional tariffs or economic developments that weaken India's growth outlook could prompt the RBI to deploy additional policy tools, such as a rate cut, to stimulate the economy.


• Global Shifts in Monetary policy: A dovish stance by the US Federal Reserve driven by unemployment concerns could lead to rate cuts, thus supporting global and Indian bond yields.


• RBI Intervention: To stabilize yields and mitigate market volatility, the RBI may consider conducting targeted Open Market Operations (OMOs) in limited quantities. Additionally, in response to prevailing demand-supply mismatches, the central bank could recalibrate the upcoming auction calendar for October 2025 to March 2026 by reducing the proportion of long-duration bond issuances within the overall borrowing program.

Conclusion

Despite structural challenges such as supply-demand mismatches and the likely end of the rate easing cycle, the current bond market dislocation presents a compelling short term tactical window. Investors may look to take advantage of this anomaly and capitalize on this opportunity for a tactical rally of 15-25bps.

Disclaimer

Source & Date: Bloomberg, Axis MF Research Date: 28 August 2025

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