Debt Outlook 2026: Will the tide turn on rates? 

To squeeze out better returns from their debt investments, investors need to anticipate moves in the rate cycle, rather than try to ride them after they play out. 2025 was a good illustration of this. In our Debt Outlook In January 2025,  we expected that the Monetary Policy Committee (MPC) would cut policy rates this year after sitting on the fence for long. 

It did. In fact, it lowered the repo rate by 125 basis points from 6.5% to 5.25% (much more than we expected) on a change of guard at RBI and weak growth worries. But market interest rates (in line with our expectations) had run ahead of repo rates and therefore did not fall as much. Not only did the 10-year gilt yield not fall much; it turned more unpredictable leading to a volatile show from long-duration and gilt funds.   

As we take stock in January 2026, we think that there is very little room left for the MPC to cut rates further. With inflation prints already at rock-bottom, we think there is now clear upside risk to both inflation and policy rates. We therefore think that debt investors should stick to the relative safety of high-quality short-term bonds, while staying off long duration bets. This is applicable only to tactical investors. 

Investors with 5-year plus horizons can continue to hold 10-year gilt or other funds that we recommend, as they aren’t in the game of timing the rate cycle. Here’s why we hold this view. 

Downcycle done

As India’s CPI (Consumer Price Index) inflation tumbled from 5.22% in December 2024 to 1.33% by December 2025, the MPC jumped off the fence and embarked on aggressive repo rate cuts from February 2025. The year saw three 25 basis point cuts and one bonus 50 basis point (in June). This took down repo rates by 125 basis points from 6.5% to 5.25% over 2025. 

Not content with repo rate cuts, the RBI also generously opened the taps of liquidity, with open market operations and a 100-basis point CRR (Cash Reserve Ratio) cut in September-November 2025. This had a salutary effect on short-term market rates, with treasury bill yields falling by between 100 and 130 basis points through the year (See table). 

However, yields on 3 to 10-year g-secs did not follow suit. Yields on 3 to 5-years g-secs dipped marginally to 6.3-6.4% while that on the 10-year g-sec hovered at 6.6% as we write this. In fact, while the MPC was busy trimming rates, India’s 10-year gilt had a fairly torrid time. Its yield fell from 6.8% to 6.3% between January and May 2025 but then firmed up to 6.6% between June and December 2025, even as MPC turned progressively dovish.

This failure of gilt yields to faithfully track policy rates, happened for three reasons: 

• Deficit worries: While market yields on treasury bills are determined by MPC actions and liquidity, long-term g-sec yields are decided mainly by the expected supply of government bonds. The quantum of government bonds likely to hit the market in any given year is decided by the size of the fiscal deficit that the Centre is running. After comfortably meeting fiscal deficit targets until last year, the Centre is facing challenges from this year. This has put upward pressure on medium to long term gilt yields.  

Post Covid, the Centre was extremely disciplined about sticking to its fiscal deficit targets and steadily beat down its fiscal deficit as a percentage of GDP.  India’s Central government fiscal deficit dropped from 9.2% of GDP in FY21 to 4.8% in FY25. It was also scrupulous in meeting the targets set in the Budget (which was far from the case earlier). This fiscal frugality was made possible by tight revenue expenditure control, runaway tax collections and double-digit growth rates in nominal GDP (the denominator for the deficit target). 

Three factors are making the 4.4% deficit target harder to reach from FY26 onwards. 

First, sharp cuts to personal income tax and GST rates in 2025 have slowed tax collection growth. Second, low inflation is dragging nominal GDP growth to 8% versus the budgeted 10.1%—shrinking the denominator for deficit calculations. Third, expanding welfare schemes and the impending 8th Pay Commission revisions (FY27) are swelling revenue expenditure.

The strain is showing. In the first eight months of FY26, revenue receipts reached only 56% of full-year targets (down from 60% last year), while the fiscal deficit hit 62.3% of estimates versus 52.5% a year ago. Capital expenditure surged to 58.7% of budget (up from 46%), even as revenue spending stayed disciplined at 57.5%. The upcoming Budget will reveal whether the Centre can meet its deficit target or let it slip—a decision that will determine if 10-year yields hold at 6.5-6.6% or climb higher.

• Global sovereign debt worries: While India has been fiscally disciplined, developed economies—led by the US—continue binging on debt and sit at record-high debt-to-GDP ratios. This has pushed bond investors to demand higher yields globally. US 10-year yields have stayed above 4% since 2025 despite aggressive Fed rate cuts.

The bigger shift came from Japan. For years, global investors profited from the yen carry trade—borrowing at zero rates to invest in riskier assets worldwide. But the Bank of Japan ended this era by hiking its policy rate to 0.75%, forcing the carry trade to unwind and setting a higher floor on global rates. With yields climbing across advanced economies, Indian gilts—despite better fundamentals but hampered by poor credit ratings—have remained elevated. This global upheaval will likely remain a wild card for Indian gilt yields ahead.

• Patchy FPI flows: With the partial opening up of Indian bonds to foreign flows and inclusion of Indian gilts in global bond indices, foreign portfolio investors (FPIs) now exert a significant influence on long-term gilt yields in India. While the equity market saw FPIs rush to exit in 2025, Indian bonds did manage to attract foreign portfolio inflows of about $6.6 billion through 2025. However, these flows are lower than the previous year and have lately turned volatile. Rupee weakness in recent times has made FPIs nervous about Indian debt. A favourable resolution to the US trade deal and stability in the Rupee will be critical for FPI flows to pick up in the year ahead. This is still up in air. 

Upside risks?

While the above factors suggest a bumpy road ahead for long-term bonds, investors need to watch closely for the MPC turning more hawkish too, in 2026. There are three factors which could prompt MPC to halt its rate cuts and look to peg up rates over the next couple of years. 

• Return of inflation: Going by its 20-year history, CPI inflation rates of sub 3% are extremely unusual in India. Such patches usually triggered by sharp drops in food prices, seldom last for long. Recent CPI prints of 0.25% to 1.3% over the last 3 months were the result of three factors – deflation in food prices due to two consecutive surplus monsoons, high base effect caused by spikes last year, unusually low crude and industrial input prices due to global recession fears. The year ahead however could see inflation prints normalise, rising back to 4% plus on the back of a) normalising food prices b) a global spiral in industrial materials, already visible in metals c) crude oil bouncing back from its extraordinary lows on geopolitical churn. All of these are high probability events. 

•  Changed CPI basket: One of the reasons why volatile food prices exercise such high influence on the CPI, is that India has been relying on an outdated base year (2011-12) to calculate its CPI. A long-delayed change in the CPI base year to 2023-24  is now imminent. With an updation in its base year, the basket of goods and services used to calculate the CPI will change dramatically. The Household Consumption Expenditure Survey, used to decide CPI baskets, indicates that in the last decade, Indian households have sharply upped their spending on services and cut back on spending on food items. Therefore, CPI revision is likely to see food lose its 48% weight in the index, with services such as transport and housing likely to gain weight. This will mean a less volatile CPI in future. But it may also mean durably higher CPI prints. Given that services inflation in India is pretty sticky in the 4-6% range, CPI inflation rates could move up with the reconstitution. The impact of the base year revision on CPI needs to be closely watched. It will be critical to MPC actions and the direction of rates in 2026 and after. 

Debt strategy for 2026

All this suggests that debt investors need to follow a three-pronged strategy in 2026:

#1 Favor short-tenour bonds (1-3 years) to avoid duration and rate risks—but only if your investment horizon is under 5 years. Longer-term investors can stay with the longer duration categories we recommend, as they’re not timing the market.

#2 Capture the AAA corporate bond premium. Heavy corporate fundraising has kept yields on 2-3 year AAA bonds at attractive spreads over gilts. Access this through corporate bond funds or short-duration funds.

#3 Rising credit risks globally in lower-rated segments. The global private credit bubble fuelling the AI race—and HNI money chasing private credit in India—is building risk in below-AAA corporate bonds. After 6-7 years without major accidents, Indian credit funds may be complacent. Avoid barely-investment-grade and sub-investment-grade bonds from finance companies. However, A and AA-rated bonds from established corporates/NBFCs still offer selective opportunities—best accessed through individual bonds, not pooled vehicles.