Indian Bonds Face Fresh Pressure as RBI Moves to Drain Record Liquidity

Indian government bonds are under renewed pressure amid efforts by the Reserve Bank of India to remove surplus liquidity in the banking system. The action follows an influx of liquidity that helped support debt prices just weeks ago. 

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Yield on the benchmark 10-year bond increased to 7.08%, following a decision by the RBI to withdraw excess liquidity worth ₹1 trillion through open market purchases of government bonds. At a particularly challenging time for the bond market, there has been a pick-up in inflation, an increase in crude oil prices and external pressure in global bonds, as well as ongoing bond sales by the government to finance its borrowings for the remainder of the fiscal year. 

There was more pain for shorter-dated bonds on Tuesday, with the yield on five-year bonds jumping by 21 basis points the largest one-day jump since May 2022 and the yield on 10-year bonds increasing by six basis points. 

From record cash surplus to liquidity withdrawal 

The change in the bond market follows an unusual build-up of money in the banking system. 

Last month, the RBI attracted a record $127 billion through special deposits from the Indian diaspora as part of its efforts to strengthen foreign-exchange reserves and support the rupee. 

Those inflows pushed surplus banking-system liquidity to an all-time high of about ₹11 trillion, equivalent to roughly $115 billion. 

That abundance of cash initially offered some protection to Indian bonds even as yields climbed sharply in other major markets. It also pushed interbank borrowing rates below the RBI’s policy benchmark. 

The picture has since changed. With higher oil prices adding to inflation concerns, the central bank is now moving in the opposite direction and withdrawing liquidity. 

Bond supply becomes another pressure point 

The RBI’s ₹1 trillion open-market sale means the central bank itself is adding bonds to the market just as the government begins borrowing for the second half of the financial year. 

That combination increases the volume of debt that investors have to absorb. 

The liquidity withdrawal may not end with the announced bond sales. QuantEco Research estimates that another ₹2 trillion may need to be removed from the banking system relatively quickly. 

Possible routes identified in the report include short-term foreign-exchange swaps, Market Stabilisation Scheme securities and cash-management bills. 

The RBI had not responded to a request for comment on its future liquidity plans at the time of the report. 

Inflation adds to rate uncertainty 

August inflation moved closer to the upper end of the RBI’s 2%-6% target range, adding another variable for bond investors. 

Market expectations cited in the report have consequently shifted towards the possibility of a 25-basis-point increase in the policy rate at the RBI’s October 7 decision. 

Citigroup has moved forward its expectation for an RBI rate increase to October from December. 

Forecasts for bond yields have also changed. ICICI Securities Primary Dealership and IDFC First Bank see the benchmark 10-year yield potentially moving beyond its May 2026 peak and reaching as high as 7.25% by December 31. If that level is reached, it would be the highest in three years. 

These remain market forecasts rather than confirmed outcomes. 

Foreign investors cut bond holdings 

Foreign flows have added to the selling pressure. 

Overseas investors reduced holdings of index-eligible Indian bonds by ₹2,470 crore on Tuesday. That followed withdrawals of ₹4,730 crore on Friday, the largest such outflow since April last year. Indian markets were closed on Monday. 

Pressure was not confined to India. Similar-maturity US Treasury yields climbed to their highest levels since 2007 later on Tuesday, adding to an already difficult global backdrop for debt markets. 

The immediate change for Indian bonds, however, has come from domestic liquidity. A banking system that recently held a record cash surplus is now facing active withdrawal by the RBI, while government borrowing, inflation concerns and foreign selling are arriving at roughly the same time.