The bond market was rewarding across the yield curve for investors in 2024, long-duration plays being the most rewarding. While liquid, money market and short-duration funds delivered well over 7 per cent on an average, according to Valueresearch data, medium-duration, banking and PSU debt, and corporate bond schemes gave in excess of 8 per cent during the year gone by.

But the most rewarding were gilt and long-duration funds that delivered 9-11 per cent returns on an average in 2024.

The 10-year G-Sec’s yield fell 43 basis points from 7.18 per cent at the start of 2024 to end the year at 6.75 per cent, while other long-dated securities too witnessed a decline in yields. Thus the longer end of the curve was the most rewarding.

Overall, every type of bond investor was rewarded according to the risk-duration play.

However, with the dawn of 2025, a range of factors are at play in a tricky macro-economic terrain and these would determine the direction of the bond market.

Inflation, interest rate (cuts), economic growth, the Centre’s fiscal math, rupee-dollar dynamics and banking liquidity would provide pointers to the bond market. From a macro perspective, prospect of trade tariffs once President Trump takes over, FPIs continued selling, China’s economic prospects, commodity cycle and inclusion of Indian securities in Bloomberg and FTSE Russell’s bond indices are key factors.

Falling inflation, watchful RBI

For the past 12 months, core inflation has been below 4 per cent. However, the overall CPI has still been a bit sticky because of food inflation (largely due to seasonality in vegetable prices) though it has fallen below 6 per cent in recent months.

But the RBI has cited higher CPI as the key factor to not cut interest rates even as the US, UK and the ECB reduced rates by 50-75 basis points over the last quarter of 2024. However, the Central bank has cut the cash reserve ratio and changed its stance from ‘withdrawal of accommodation’ to neutral.

There has been a slowdown in India’s economy in the past couple of quarters. The September-quarter GDP growth was below 6 per cent, thus raising the chorus for interest rates to be cut from the industry.

There has been a change of guard in the RBI, but inflation may still be a key monitorable.

The Federal Reserve sprung a surprise indicating that only a 50-basis point cut in 2025 may be possible, even as expectations were for a lot more.

For India, the general expectation is that there may be only two rate cuts in 2025 from the RBI, of 25 basis points each, totalling to 50 basis points.

Rupee-dollar dynamics

After remaining resilient for much of 2024, the rupee finally started its decline against the dollar from December. With relatively-strong US economic data, Trump victory and tariff threat, the dollar has strengthened against most global currencies.

Some reports suggest that the RBI spent $44 billion trying to defend the rupee in October alone. The rupee is now following most other Asian currencies in its downward trajectory from sub-84 levels to nearly 85.8 against the dollar.

In short, the long-term trend of a 3-4 per cent annual decline against the dollar may resume after a lull, with the possibility of some sharp declines in case there are tariff shocks.

FPIs selling in the equity markets is another negative for the rupee. In the bond market, FPIs reportedly bought securities worth a little more than ₹1.2 lakh crore in 2024.

US bond yields spiked after the Fed indicated lower rate cuts. If higher US yields and a weaker rupee push FPIs to pull out from the bond market to redeploy in US bonds, Indian G-Sec yields may spike as bond prices fall.

However, the G-Sec supply-demand dynamic is robust. Domestic mutual funds, insurance companies, pension funds (EPFO) and other institutions could still keep demand for G-Secs healthy.

Another mitigant could be the inclusion of Indian bonds in global indices such as Bloomberg and FTSE Russell in early- to late-2025, which could bring greater inflows and possibly reduce yields even if marginally.

Banking liquidity

After being in surplus for around six months from April, banking liquidity has gone into deficit from December. Despite a 50-basis point cut in cash reserve ratio (25 basis points each effective from mid- and end-December 2024), which infused ₹1.16 lakh crore in liquidity, the banking system faced a crunch. Reports suggest that the liquidity deficit was over ₹2 lakh crore towards the end of December. The crunch continues in January as well. Eventually, the RBI may conduct open market operations, and also use variable rate repo and cash reserve ratio to bring back liquidity, though the timelines aren’t certain.

This short-term liquidity deficit is having an impact on bond market yields.

Call rate was at a one-year high of 6.88 per cent on January 1 this year. Refinitiv and CCIL data, compiled by Kotak Mutual Fund, indicates that the three-month commercial papers trade at yields of 7.48 per cent (up 38 basis points in the last six months), while three-month certificates of deposit trade at 7.17 per cent (up 10 basis points in the six months).

What should bond investors do?

Despite expectations of a shallow rate cut from the RBI, long-term G-Secs may still see yields falling significantly, though perhaps not as spectacularly as in 2024. The Centre’s fiscal math with deficit expected to come down to 4.9 per cent in 2025 and 4.5 per cent in 2026 are positives.

One interesting aspect is that three- and five-year AAA-rated corporate bonds have seen yields fall only 5-10 basis points over the past one year and yields continue to be close to 7.5 per cent.

At the shorter end of the curve, one-year CPs and CDs still offer 7.6 per cent to 7.7 per cent yield.

For bond investors, staying with long-duration, gilt funds and gilt funds with constant maturity may still be advisable for a larger part of their portfolio in 2025.

However, given the reasonably attractive yields on three-month and one-year papers, even money market, liquid and short-duration funds can be considered by conservative investors for short-term needs.

Given the lack of movement in yields in three- and five-year bonds, even medium-duration funds that invest in such securities can be considered selectively.

Published on January 4, 2025