India's Bond Market: Riding the Yield Curve Steepening Ahead of the RBI Rate Cut

The Reserve Bank of India (RBI) is on the brink of delivering its third consecutive rate cut in 2025, dropping the repo rate to 5.75% and fueling expectations of further easing. Against this backdrop, India's bond market is experiencing a historic moment: the 10-year government bond yield has plummeted to a multi-year low of 6.21%, while liquidity surpluses hover near record highs. For fixed-income investors, this environment presents a unique opportunity to capitalize on a steepening yield curve—a phenomenon that rewards overweighting duration exposure in long-dated bonds. But with state debt supply set to surge and inflation risks lurking, the path to profit is not without pitfalls.

The Case for a Steeper Yield Curve: Growth vs. Liquidity

The RBI's shift to an “accommodative” stance since April 2025 has been a lifeline for bond markets. With inflation dipping to 3.16%—well below the 4% target—the central bank has prioritized economic growth over tightening. This has driven short-term rates sharply lower, while long-term yields have fallen at a slower pace, creating a steepening yield curve.

The gap between the repo rate and the 10-year yield has widened from -30 basis points (bps) in March to +46 bps in June, signaling investor confidence in the RBI's ability to sustain growth without reigniting inflation. This dynamic is critical for bond investors: longer-dated bonds (e.g., 10–30-year maturities) now offer a compelling risk-reward trade-off.

Why Overweight Duration Now?

1. Liquidity Surplus Buffer:
   The banking system's daily liquidity surplus has soared to ₹1.71 trillion, the highest since July ontvangen 2022. This excess cash is a safety net for bond markets, absorbing state debt issuances and cushioning yields against upward pressure.

2. RBI's Forward Guidance:
   Analysts like ICRA's Aditi Nayar expect two more rate cuts by year-end, potentially pushing the repo rate to 5.25%. This path implies further declines in short-term rates, which could accelerate the yield curve's steepening.

3. State Debt Dynamics:
   While state governments plan to issue ₹294 billion in bonds this month—the largest single-day supply since FY2025 began—the RBI's liquidity injections and investor demand for Sovereign Green Bonds (SGBs) (which debuted at ₹5,000 crore in June) should mitigate oversupply risks.

Risks on the Horizon

• Supply Shock: If state debt auctions undersubscribe, yields could spike, flattening the curve and hurting long-dated bonds. Monitor the June 2025 state bond auction results closely.
• Inflation Surprise: A rebound in crude oil prices or pent-up demand post-rate cuts could force the RBI to pause easing. Track India's WPI and CPI data for clues.
• Global Headwinds: The U.S. Federal Reserve's prolonged high rates and emerging market outflows could weaken the rupee, indirectly pressuring bond yields.

The Investment Play: Duration Overweight

For fixed-income portfolios, the sweet spot lies in long-dated government and corporate bonds with maturities of 10–30 years. Key picks include:
- 10-year Government Bonds: Current yields of 6.21% offer a premium over short-term instruments, amplified by the steepening curve.
- Sovereign Green Bonds (SGBs): Their debut attracted eco-conscious investors, and their “green premium” could widen if demand exceeds supply.
- AAA-rated Corporate Bonds: Firms like NHPC (hydroelectric projects) and HUDCO (urban infrastructure) offer yields +50 bps above government bonds, with low default risk.

Final Verdict: Act Before the RBI Speaks

The RBI's June 6 policy meeting is a make-or-break moment. If the central bank delivers a 50 bps cut (as some analysts speculate), the yield curve could steepen further, rewarding duration-heavy portfolios. Even a 25 bps cut will reinforce the accommodative bias, keeping long-term yields anchored.

Act now: Position your portfolio for the steepening curve by overweighting long-dated bonds. Monitor liquidity metrics and state debt auctions, but don't let fear of supply overhang outweigh the tailwinds of low inflation, ample liquidity, and RBI support. This is a once-in-a-cycle opportunity—don't miss it.