India's Bond Market: Navigating Liquidity Shifts and External Pressures in Q3 2025

The Indian bond market enters Q3 2025 at a crossroads, balancing RBI-driven liquidity tailwinds against the headwinds of FPI outflows, a weakening rupee, and evolving fiscal dynamics. As muted volatility masks underlying uncertainties, investors must parse policy cues and structural risks to position portfolios tactically. This analysis outlines how to navigate short-term opportunities while hedging against prolonged external pressures.

RBI's Liquidity Play: A Double-Edged Sword

The Reserve Bank of India's June 2025 policy shift to a neutral stance, alongside a 50-basis-point rate cut, aimed to bolster growth without compromising inflation control. While the CRR reduction to 3% by end-2025 will inject ₹2.5 lakh crore into the banking system, the immediate impact on bond yields has been muted.

Key Takeaway: Short-end yields (5-year bonds) now offer better liquidity and lower sensitivity to rate hikes compared to long-dated paper. Investors should prioritize duration compression, focusing on maturities of 3–5 years until Q4 policy clarity.

FPI Outflows: A Feedback Loop of Weakness

Foreign Portfolio Investors (FPIs) withdrew a cumulative $3.57 billion from India's bond market through June 2025, driven by two factors:
1. Rupee Depreciation: The USD-INR pair rose to ₹83/$1, eroding returns for unhedged investors amid a global “dash for dollars.”
2. Global Rate Differentials: U.S. 10-year yields hovering near 4.5% reduced India's bond appeal, with spreads narrowing to <200bps.

Risk Alert: A break above ₹85/$1 could trigger further outflows, especially if U.S. Treasury yields remain elevated.

Fiscal Signals: State Borrowing and Its Shadow

While the Centre's fiscal deficit is on track to 4.4% of GDP, state borrowings loom as an overhang. Several states, including Maharashtra and Tamil Nadu, may revise upward their ₹10.5 lakh crore FY2025–26 borrowing plans, driven by delayed reforms and infrastructure spending.

Investment Caution: Over-borrowing could compress yields further, particularly in the 10–20 year segment. Avoid long-dated bonds until clarity on state budgets emerges post-Monsoon session.

Tactical Opportunities: Short End and Technicals

Despite the risks, two entry points exist for contrarian investors:
1. Quarter-End Liquidity Surge: Banks, seeking to meet CRR requirements, often reduce bond holdings ahead of quarter-end. This creates a short-term buying opportunity in short-dated papers.
2. Yield Thresholds: A breach below 6.25% on the 10-year yield—a level last seen in early 2024—could signal a resumption of FPI inflows, especially if the rupee stabilizes.

Positioning Strategy: Wait-and-See Until September

• Short-Term:
• Buy 3–5-year bonds at yields >6.5% for capital appreciation.
• Hedge USD risk using forward contracts if FPIs remain net sellers.
• Long-Term:
• Avoid duration extension until the RBI's September policy signals further easing.
• Monitor U.S. Fed actions: A rate cut before October 2025 could ease dollar strength, reducing rupee pressure.

Final Call: Remain neutral-to-slightly bullish on short-dated bonds but avoid aggressive bets until September's RBI policy meeting and Q3 U.S. inflation data clarify the global rate outlook.

In a market where liquidity and policy are the twin engines, patience and precision are rewarded. The bond market's next chapter hinges on whether external pressures fade or fiscal discipline holds. For now, stay nimble.