India's Evolving Bond Market Dynamics and Implications for Sovereign Risk

India’s bond market is undergoing a profound transformation, driven by structural shifts in issuance strategies, evolving bank risk exposure, and fiscal sustainability goals. These dynamics are reshaping yields, investor behavior, and long-term borrowing costs, with significant implications for sovereign risk.

Structural Shifts in Bond Issuance: A Longer-Term Horizon

India’s central and state governments have extended the average life of their bond portfolios, with the Indian government bond market now averaging 7.3 years in duration and an effective duration of 14 years—substantially longer than U.S. Treasuries, which hover below 9 and 6 years, respectively [3]. This shift reflects improved fiscal management, as the fiscal deficit has narrowed from over 6% of GDP to 4% in 2023-24, with a target of 4.4% for FY2025-26 [4].

Simultaneously, sustainable finance is gaining traction. Cumulative green, social, and sustainability-linked (GSS+) debt issuance reached USD 55.9 billion by December 2024, a 186% increase since 2021 [2]. The government’s sovereign green bonds, totaling INR 477 billion since 2023, underscore this trend. These structural changes are further amplified by the inclusion of Indian government bonds in global indices like the FTSE EMGBI, AGBI, and APGBI from September 2025, which is expected to attract foreign inflows and enhance liquidity [3].

Bank Risk Exposure and RBI Interventions: A Tipping Point?

Indian banks are nearing internal prudential limits for state bond holdings, with public sector banks approaching 45-55% exposure and private banks at 15-20% [1]. This has led to weak demand in state bond auctions, where states have raised less than their target amounts in recent weeks. For instance, states have completed only 26% of their planned FY2025-26 borrowing, raising concerns about liquidity and borrowing costs [1].

The Reserve Bank of India (RBI) is actively addressing these pressures. In late August 2025, it convened consultations with banks and primary dealers to discuss the second-half borrowing calendar, signaling urgency as yields on the 10-year benchmark bond rose 19 basis points in August [2]. Banks have flagged mark-to-market losses from rising yields and called for reduced issuance of ultra-long bonds (30–50 years) to align with weak demand. Analysts suggest potential interventions, such as open market operations (OMO) or Operation Twist, to stabilize yields [3].

Fiscal Sustainability and Tax Policy: Balancing Act

India’s government debt-to-GDP ratio stood at 81.59% in 2023, with a long-term target of 50% by 2031 [1]. While the fiscal deficit target of 4.4% for 2025-26 reflects fiscal prudence, recent tax policy changes, including a GST overhaul and income-tax simplification, have introduced revenue uncertainties. The GST rate cuts, for example, are estimated to reduce government revenue by 480 billion rupees ($5.5 billion), below initial economist forecasts but still impactful [4].

These fiscal pressures are compounded by a widening yield-repo spread of 100 basis points, signaling prolonged policy caution [4]. The government’s reliance on debt issuance to offset revenue shortfalls could strain fiscal sustainability, particularly if state borrowing accelerates.

Strategic Entry Points for Investors

For investors navigating this evolving landscape, several opportunities and risks emerge:
1. Sustainable Bonds: The surge in green and social bonds offers diversification and alignment with global ESG trends. However, liquidity constraints in the corporate bond market—where institutional investors hold over 95% of holdings—remain a challenge [4].
2. Yield Volatility: The RBI’s potential interventions, such as OMO, could stabilize yields, creating entry points for long-term investors. However, the current yield-repo spread suggests caution.
3. State Bonds: While state bond yields have spiked, the RBI’s consultations may mitigate short-term risks. Investors should monitor auction dynamics and fiscal health of individual states.

Conclusion

India’s bond market is at a crossroads, balancing structural resilience with emerging risks. The extension of maturities and focus on sustainable finance bolster long-term stability, but banks’ risk limits and fiscal pressures pose near-term challenges. The RBI’s proactive engagement and potential interventions will be critical in shaping the market’s trajectory. For investors, a nuanced approach—leveraging sustainable bonds while hedging against yield volatility—offers a path to capitalize on India’s evolving bond landscape.

Source:
[1] India Banks Tell RBI They've Limited Room to Buy State Bonds [https://www.bloomberg.com/news/articles/2025-09-02/indian-banks-tell-rbi-they-ve-limited-room-to-buy-state-bonds]
[2] RBI to Meet Bond Market This Week to Discuss Second-Half Borrowing: Report [https://m.economictimes.com/markets/bonds/rbi-to-meet-bond-market-this-week-to-discuss-second-half-borrowing-report/articleshow/123647865.cms]
[3] A Resilient Indian Fixed Income Market [https://www.lseg.com/en/insights/ftse-russell/a-resilient-indian-fixed-income-market]
[4] India Targets Fiscal Deficit at 4.4% for 2025-26, Sets Path to Bring Down Debt [https://www.reuters.com/world/india/india-budget-india-targets-fiscal-deficit-44-2025-26-sets-path-bring-down-debt-2025-02-01/]