The Indian fixed income market is witnessing a significant surge in the popularity of bond carry trades, a strategy where investors aim to profit from the difference between low short-term borrowing costs and higher yields on longer-dated bonds. Market analysts predict this trend will dominate trading strategies well into the next year.
The Mechanics of the Popular Trade
Currently, investors can capture a spread of around 1 percentage point, the most attractive in over two years, by borrowing funds in the overnight market and using the capital to purchase five-year government notes. This opportunity stems from the Reserve Bank of India's (RBI) monetary policy stance. The central bank projects only a gradual rise in inflation toward its 4% target, fueling expectations that interest rates will remain stable for the foreseeable future.
This environment has led to increased activity from major players. International banks with onshore bond trading desks in India are among those scaling up their positions, according to market sources familiar with the developments. The people requested anonymity due to the confidential nature of the trading activities.
A Conservative Strategy in a Stable Rate Environment
The shift towards carry trades reflects a more conservative approach to benefit from India's high bond yields without betting heavily on price appreciation. "Next year will be more of a carry trade year rather than outright capital gains as it’s going to be a two-way market," explained Vikas Jain, head of India fixed income, currencies and commodities trading at Bank of America. He highlighted that the policy rate at 5.25% presents a solid opportunity to execute this trade using state bonds or short-maturity government securities.
This strategy gains traction even as the RBI's room for further rate cuts appears limited after it reduced the policy rate to a more than three-year low earlier this month. The central bank has indicated potential for more easing only if inflation remains subdued.
Demand has concentrated most powerfully in three- to five-year bonds over the past three months, causing short-term debt to outperform longer maturities. Consequently, the yield gap between three-year and ten-year notes has widened by approximately 25 basis points since early September.
Drivers and Inherent Risks
"The primary drivers supporting these carry trades are surplus banking liquidity, which keeps overnight rates near the policy rates, and the anticipated maintenance of policy rates at current levels over the coming quarters," said Sameer Karyatt, head of trading at DBS Bank in Mumbai.
However, experts caution that the trade is not without risk. A sharp rise in short-term yields could trigger mark-to-market losses that erase the carry benefit. Furthermore, a sudden spike in inflation or renewed volatility in the Indian rupee—which has touched multiple record lows recently—could quickly diminish returns, as noted by Australia and New Zealand Banking Group (ANZ).
"Focusing on short-term bonds helps limit market risk," stated VRC Reddy, head of treasury at Karur Vysya Bank, adding that the preference for shorter tenures also mirrors expectations that deep rate cuts are unlikely soon.
Despite the risks, institutions like DBS and ANZ expect carry trades to remain a fixture in India's bond market into 2026. "The locally funded carry trades thrive in an environment of stable to lower funding rates," said Nitin Agarwal, head of trading at ANZ in Mumbai. "The three-to-five year segment has done reasonably and is expected to benefit from this theme."
