Bond yields may fall to 6% as inflation cools and liquidity stays strong: Report

The bond market could see further gains in the coming months, with 10-year government bond (IGB) yields likely to soften to 6% from the current 6.25%, according to a new report by Bandhan Bank. The upbeat forecast is backed by a combination of favourable macroeconomic factors, including cooling inflation, robust system liquidity, and expectations of further repo rate cuts by the Reserve Bank of India (RBI).

Retail inflation is showing signs of stability, largely driven by easing food prices and steady core inflation. "We expect headline CPI to average close to 4% during FY26," the report stated, suggesting that price pressures are unlikely to derail economic momentum.

Despite strong GDP growth of 7.4% in Q4FY25, the RBI is expected to maintain a growth-friendly stance. Bandhan Bank anticipates another 50-bps cut in the repo rate during FY26, which would take it closer to the neutral rate and support lower bond yields.

The banking system remains flush with liquidity, thanks in part to proactive measures by the central bank. A major boost came from the RBI's record surplus transfer of ₹2.68 lakh crore to the central government for FY25. This, according to the report, is "positive for system liquidity and should help the government meet the FY26 fiscal deficit target of 4.4%."

Bank credit growth has slowed sharply, from 16.3% in March 2024 to around 11% currently, reflecting subdued demand for retail and industrial loans. This sluggish trend is expected to persist through FY26.

At the same time, the yield gap between Indian government bonds and US Treasuries has narrowed, a sign that investors are demanding a lower risk premium for Indian debt. “With India’s disciplined fiscal glide path and narrowing inflation differential, one expects this trend to persist,” the report noted.

Summing up, Bandhan Bank believes the environment remains supportive for bonds. “With benign inflation outlook, more repo rate cuts, persisting banking system liquidity surplus, a low double-digit credit growth, and likely decent FPI interest, one feels that the rally in Indian bonds is not yet over,” it said.

Amit Jain, co-founder of Ashika Global Family Office Services, said, "A decline in bond yields to around 6% would act as a strong tailwind for equity valuations. Lower yields reduce the discount rate used in valuation models, making future cash flows more valuable—this tends to expand P/E multiples, especially for high-quality, growth-oriented companies."

"In terms of sector preferences, lower yields typically favour rate-sensitive sectors like banking, real estate, and capital-intensive businesses, as borrowing costs decline and credit demand improves. Additionally, consumer-facing sectors like FMCG and auto may benefit from improved sentiment and liquidity. I see this environment as supportive for a broad market re-rating but remain focused on companies with strong balance sheets and earnings visibility," added Jain.

However, the report also cautioned that risks such as erratic monsoons, geopolitical tensions, or a resurgence of Covid-19 could disrupt the bond market outlook. If all goes well, yields on the 10-year benchmark bond could fall to 6% over the next 3 to 6 months, with a “further downside bias.”

"If 10y goes to 6%, investors need to be in medium-term bonds for any further gains as the curve should steepen more as room for further cuts becomes less, and long-term would not rally more," says Vishal Goenka, co-founder at IndiaBonds.com.