Bond carry trades, which seek to profit from the gap between low funding costs and high bond yields, are growing ever more popular in India and market watchers expect the strategy to remain in vogue next year.
Investors can pick up around 1 percentage point, the most in over two years, by borrowing overnight and using the proceeds to buy five-year notes. The Reserve Bank of India is projecting only a gradual rise in inflation toward its 4% target, fueling expectations that interest rates aren’t likely to head higher for a while.
International banks that have bond trading desks in India are among those piling into the trade and have increased the size of their positions, according to five people familiar with the matter. They declined to be identified because the trading activities are confidential.
Next year “will be more of a carry trade year rather than outright capital gains as it’s going to be a two-way market,” said Vikas Jain, head of India fixed income, currencies and commodities trading at Bank of America. “With the policy rate being low at 5.25%, it gives a very good opportunity to put on a carry trade through state bonds or short maturity government securities.”
Conservative strategy
The shift reflects a conservative strategy to benefit from high yields on Indian bonds in a low inflation environment, even as the central bank is left with limited room to cut rates further. The RBI cut its policy rate to a more than three-year low earlier this month, and signalled it could ease further if inflation readings remain soft.
Demand has picked up most strongly in three- to five-year bonds over the past three months, helping short-term debt outperform longer maturities. The yield gap between three- and 10-year notes has widened by about 25 basis points since early September, as weak demand pushed long-term yields to a three-month high while short-term yields have remained relatively stable.
“The primary drivers supporting these carry trades are surplus banking liquidity, which keeps overnight rates near the policy rates, and the anticipated maintenance of policy rates at current levels over the coming quarters,” said Sameer Karyatt, head of trading at DBS Bank in Mumbai.
Still, the trade isn’t risk-free. A sharp rise in short-term yields could trigger mark-to-market losses that outweigh the carry. A sudden jump in inflation or renewed rupee volatility — the currency has hit a string of record lows in recent weeks — could quickly eat into returns, according to Australia and New Zealand Banking Group.
Focusing on short-term bonds helps limit market risk, said VRC Reddy, head of treasury at Karur Vysya Bank. The preference for shorter bonds also reflects expectations that deep rate cuts are unlikely in the near term, he said.
Both DBS and ANZ expect carry trades to remain a part of India’s bond market into 2026.
“The locally funded carry trades thrive in an environment of stable to lower funding rates,” said Nitin Agarwal, head of trading at ANZ in Mumbai. “The three-to-five year segment has done reasonably and is expected to benefit from this theme.”