“If you wanna learn about supply and demand, go meditate in a forest,” said Hendrith Vanlon Smith Jr, CEO of Mayflower-Plymouth. While this is certainly in a lighter vein, as far as Indian bonds go, there is certainly a gap between demand and supply that is going to skew figures in this asset class.
Here too, even in an apparently boring economic treatise, there is money to be made.
The core issue is that demand-side incentivisation for debt papers has been lacking. Regulatory changes have gradually nudged long-term investors such as Pension and Insurance funds to incrementally allocate more towards equity, says Rajeev Radhakrishnan, CFA, CIO- Fixed Income, SBI Mutual Fund.
Until recently, this demand–supply gap was largely masked by index-driven FPI inflows and substantial RBI open market operations. But with index flows tapering and surplus liquidity reducing the need for RBI purchases, the imbalance has begun to show. As a result, bond yields have drifted higher this financial year, even as the RBI has continued to cut rates.
The past few years also saw a positive tailwind from higher tax collections. With the impact of income tax cuts and GST reductions, this tailwind has also subsided for the near term.
“The volume of supply at the long-end is outpacing what long-duration buyers are willing or able to absorb,” says Tushar Sharma (Co-Founder Bondbay, Platformed by Dexif Securities).
The impact of weak demand is visible with yields drifting upwards even in an easing monetary policy environment, with the worst-case estimate only looking at a prolonged pause from the RBI and not any immediate reversal in policy direction. The persistence of current trends would keep yields higher than warranted based on the evolving macro-economic landscape.
If major institutional investors such as banks, insurers, FPIs, or the RBI pull back from buying government bonds and auction participation weakens too, this typically causes bond prices to fall, which in turn pushes yields higher because yields move inversely to prices.
Weak demand also widens bid–ask spreads, increases auction tail risks, and pushes issuers to offer higher interest rates to clear the supply. In essence, as institutional appetite fades, the market requires a higher risk premium, resulting in an upward drift in yields across tenors.
Banks are constrained by SLR (Statutory Liquidity Ratio) and HTM (Held-to-Maturity) norms, which limit incremental bond purchases and increase sensitivity to mark-to-market losses. Insurance companies and pension funds are either shifting allocations (e.g., more into equities) or facing limited incremental inflows into long-duration mandates. FPIs remain cautious given currency and global rate risks, limiting their participation as a demand back-stop.
Yet, there are certainly some benefits from these economic dynamics.
“Weak demand implied higher coupon rates on fresh issuances and hardening yields on existing bonds,” says Radhakrishnan.
If institutional demand remains weak, the government may be compelled to offer higher coupon rates on new bond issuances to ensure adequate investor participation in auctions, says Sharma.
In a market where borrowing requirements remain large, and the pool of natural buyers has thinned, raising coupon rates-or equivalently, accepting higher cut-off yields-becomes the most direct way to attract sufficient demand. This adjustment makes fresh issuances more appealing to investors seeking better accrual returns relative to prevailing market levels.
Certainly, too, there is scope for making money in this environment.
“A persistent demand–supply imbalance that drives yields to higher benefits for several debt categories,” says Harsimran Singh Sahni, Executive Vice President – Treasury Head, Anand Rathi.
Over the medium term, 3–7-year target maturity funds become attractive by locking in elevated yields with relatively low volatility. Over longer horizons, dynamic bond funds and gilt funds can capitalise on shifting opportunities across the curve. “These categories are best positioned to capture the uplift in yields created by persistent issuance and softer demand,” says Sahni.
Focus on short-term high-grade bond funds to optimise duration and credit risk as part of the core debt allocation, says Radhakrishnan. AAA-bond spreads are attractive at the shorter end and could benefit from a lesser supply and adequate system liquidity. A moderate duration risk remains ideal from the perspective of benefiting from any further policy rate cuts from the central bank.
MF categories that will gain from bond demand-supply mismatch
The prevailing demand–supply imbalance in India’s bond market – driven by elevated sovereign issuance and a moderation in institutional demand – has created an environment of higher yields and wider spreads, says Sharma.
While this raises near-term borrowing costs, it also presents opportunities for fixed-income investors. Mutual fund categories and bond-linked asset classes that prioritise accrual income, duration flexibility, and high credit quality are well-positioned to benefit from the current phase, he opined.
Short Duration and Low Duration Debt Funds: Short-duration funds, which invest in securities maturing within one to three years, stand to gain from reinvesting at elevated yield levels caused by the supply overhang. With limited interest rate sensitivity, these funds provide stable returns through high accrual income and low volatility. The shorter maturity profile ensures quick portfolio turnover, enabling investors to capture rising yields without substantial mark-to-market risk.
Corporate Bond Funds and Banking & PSU Debt Funds: High-grade corporate and quasi-sovereign issuers are currently offering wider spreads over comparable government securities. Corporate Bond Funds and Banking & PSU Debt Funds can capitalise on this spread expansion to enhance portfolio yields while maintaining conservative credit exposure. These categories provide the right balance between safety and higher income potential, appealing to investors seeking incremental returns over traditional gilt funds.
Dynamic Bond Funds: Dynamic Bond Funds have the flexibility to actively adjust duration in response to market movements. In a scenario of volatile yields and inconsistent institutional demand, these funds can tactically shift between short and long maturities, taking advantage of price dislocations across the curve. This allows investors to benefit from professional duration management and opportunistic positioning, without needing to time the market themselves.
Target Maturity Funds (TMFs): TMFs investing in government, PSU, or SDL bonds of defined maturity offer predictable returns with minimal active management. In a phase of elevated yields, these funds allow investors to lock in high rates for the next 3–7 years, benefiting from both accrual income and a roll-down effect as the fund approaches maturity. Their passive structure and tax efficiency make them particularly suitable for retail investors seeking stable, fixed-tenure exposure.
Short-Term and Constant-Maturity Gilt Funds: The 5–10 year segment of the sovereign yield curve currently offers attractive term premia due to concentrated supply. Short-term gilt funds and constant-maturity gilt funds can accumulate securities at elevated yields and benefit from capital appreciation once demand normalises or RBI’s interventions support secondary market liquidity. For investors with moderate risk tolerance, these funds provide a pure-play exposure to government securities with potential upside.
Bond ETFs, Bharat Bond Funds, and Fixed Maturity Plans (FMPs): Passive bond investment vehicles – including Bharat Bond ETFs and FMPs – allow investors to efficiently capture high prevailing yields with minimal tracking error or management costs. FMPs launched during such phases of yield elevation can lock in attractive returns for their fixed tenure. These instruments suit investors preferring a buy-and-hold structure, predictable cash flows, and sovereign or quasi-sovereign credit exposure.
Fund managers’ strategy in a dynamic bond situation
“If fund managers continue to adjust duration proactively, retail investors gain by accessing expert, real-time bond-market decisions without directly managing the complexities of the bond market on their own,” says Sahni.
Categories such as dynamic bond funds and active gilt funds allow households to indirectly capture yield opportunities at attractive entry points while being shielded from abrupt rate swings. Investors, therefore, benefit from well-timed duration shifts executed on their behalf.
Overall, on a risk–reward basis, spreads on high-grade bonds as well as selective credits at the shorter end remain attractive. Given the anticipated external volatility and its likely resetting of market expectations, strategies on duration would continue to be nimble. This translates to fund managers switching between bonds based on their duration.
“Yes, the period of maintaining a higher duration to ride out an easing cycle is clearly over,” says Radhakrishnan. In the current environment, duration needs to be addressed tactically, and the core strategy would be incrementally on high-grade bonds and carry in most portfolios. (In bond terminology, carry is the interest income minus any cost of funding, if any.)
How can retail investors benefit from this?
“We advise conservative retail investors (both on credit and interest rate risk) to consider short-term funds and a corporate bond fund as part of the core debt allocation in the current environment. Those with a credit appetite can consider medium-duration funds,” says Radhakrishnan.
(Manik Kumar Malakar is a freelance writer covering bonds and personal finance.)
Disclaimer: This story is for educational purposes only. The views and recommendations expressed are those of individual analysts or broking firms, not Mint. We advise investors to consult with certified experts before making any investment decisions, as market conditions can change rapidly and circumstances may vary.
