Yield curve expected to flatten through 2026: Here’s a playbook from Axis Mutual Fund

After two years of transformative shifts in India’s fixed-income landscape, the "easy gains" from aggressive duration bets are giving way to a more nuanced environment. According to the Axis Mutual Fund Annual Fixed Income Outlook 2026, the bond market is transitioning from the liquidity-fuelled steep curves of 2025 toward a structural flattening of the yield curve in 2026.

For investors, this shift calls for a new playbook centred on accrual and barbell strategies.

Macro view: From steep to flat

In 2025, the yield curve steepened significantly as the RBI implemented a cumulative 125 basis points reduction in policy rates and injected approximately ₹12 lakh crore in liquidity through cash reserve ratio (CRR) cuts and open market operations (OMOs). This kept short-term rates suppressed while long-term yields found its way upward in anticipation of the end of the rate-cut cycle.

However, the outlook for 2026 suggests this trend is reversing due to several key drivers:

As the system moves toward neutral liquidity, aligning with the RBI's expected extended pause on interest rates throughout 2026, short-term rates are projected to rise relative to long-term rates. This dynamic is expected to lead to a structural flattening of the yield curve.

• Credit vs. deposit mismatch: Recovery in retail credit demand is accelerating, but weak deposit growth continues to pose concerns. This dynamic is expected to exert upward pressure on short-term bond yields.

• Structural demand for long bonds: The probable inclusion of Indian government bonds in the Bloomberg global aggregate index could attract $25-30 billion in inflows. This massive demand for long-duration bonds, alongside continued RBI OMOs, will likely anchor long-end yields even as short-end rates rise.

The 2026 playbook: Accrual and barbell

Axis mutual fund suggests that a barbell strategy is the optimal approach in a flattening yield curve environment. This involves focusing on the two ends of the maturity spectrum while avoiding the middle.

The short end: Accrual via corporate bonds

With short-term yields under pressure from tightening liquidity, the playbook recommends 2-year AA corporate bonds for steady accrual income.

Yield advantage: As of late December 2025, 2-year AA corporate bonds offered a yield of 7.71%, providing a significant "carry" or interest income cushion for investors.

The long end: Tactical duration via G-Secs

At the other end of the "barbell," the strategy calls for exposure to long-term government bonds (G-Secs) to capture potential tactical gains and index-inclusion alpha.

Yield range: Long bonds are currently trading in the 7.25-7.40% range.

Safety cushion: With the RBI expected to maintain an extended pause and no rate hikes anticipated for the next 12 months, these instruments offer a safety cushion and protection against curve flattening.

Risks to the playbook

While the "flattening" theme is the base case, Axis MF identifies three primary risks that could disrupt this strategy:

• Fiscal stress: Larger-than-expected government borrowing in FY27 could push long-term yields higher if foreign inflows disappoint.

• Index delays: If the inclusion of Indian bonds in the Bloomberg index is delayed or fails to occur, the demand-supply balance for long-duration bonds could be upset.

Growth weakness: Sustained domestic economic weakness could prompt the RBI into further easing, which might steepen the curve again.

Adaptation is recommended for 2026. By combining 2-year AA corporate bonds for yield and long-duration government bonds for tactical gain, the Barbell strategy aims to reduce downside risk while maintaining exposure to the highest-yielding segments of the market.