Investors Turn to Short-Term Bonds as Carry Trade Opportunities Expand
India’s short-term bond market is witnessing a surge in investor interest as carry trades become increasingly attractive amid low funding costs and relatively high bond yields. Market participants say investors can currently earn close to a 1 percentage point pickup—the highest in more than two years—by borrowing overnight and deploying the proceeds into five-year government securities.
This growing preference reflects a broader shift in strategy among domestic and global investors, who are prioritising steady income over aggressive capital gains. With inflation expected to rise only gradually toward the Reserve Bank of India’s (RBI) 4 percent target, interest rates are widely seen as unlikely to move higher in the near term.
“Next year will be more of a carry trade year rather than outright capital gains,” 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 percent, it gives a very good opportunity to put on a carry trade through state bonds or short-maturity government securities.”
Why Carry Trades Are Back in Focus for Bond Investors
Bond carry trades involve borrowing at low short-term rates and investing in higher-yielding bonds, earning the spread as income. In the current environment, this strategy has become particularly compelling due to a rare combination of surplus liquidity, stable policy rates, and attractive yields on short-duration debt.
International banks with bond trading desks in India have stepped up participation in these trades, according to people familiar with the activity. The renewed interest underscores confidence that funding costs will remain benign while yields on three- to five-year bonds stay elevated.
The shift also highlights a more conservative approach by investors who are wary of volatility at the long end of the yield curve and limited scope for sharp rate cuts.
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Short-Term Bonds Outperform as Yield Curve Steepens
Demand has been strongest in the three- to five-year segment over the past three months, helping short-term bonds outperform longer-dated securities. During this period, the yield gap between three-year and 10-year government bonds has widened by around 25 basis points.
This divergence has been driven by:
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Weak demand for long-term bonds, pushing yields to a three-month high
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Stable short-term yields supported by surplus liquidity
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Expectations that policy rates will remain steady for several quarters
As a result, investors seeking predictable returns are increasingly favouring shorter maturities, where carry is more reliable and mark-to-market risks are relatively contained.
RBI’s Policy Stance Supports Carry Trade Strategy
The RBI’s recent actions have further strengthened the case for short-term bond strategies. Earlier this month, the central bank cut its policy rate to a more than three-year low and signalled that it could ease further if inflation continues to remain soft.
At the same time, policymakers have indicated limited room for aggressive rate cuts, suggesting a prolonged period of stable funding costs rather than a sharp easing cycle.
“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.
Risks Remain Despite Attractive Carry Returns
While the carry trade looks compelling, market participants caution that it is not without risks. A sudden spike in short-term yields could lead to mark-to-market losses that outweigh the income earned from carry.
Key risks include:
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An unexpected rise in inflation
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Renewed volatility in the rupee, which has touched record lows in recent weeks
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A sharp tightening of liquidity conditions
Australia and New Zealand Banking Group (ANZ) has warned that any abrupt shift in macro conditions could quickly erode returns, particularly for leveraged positions.
Preference for Short Duration Seen as Risk Management Tool
Focusing on short-term bonds helps limit exposure to large price swings, making the strategy appealing in a two-way market. Treasury managers say the preference for shorter maturities also reflects the view that deep rate cuts are unlikely in the near term.
“Focusing on short-term bonds helps limit market risk,” said VRC Reddy, Head of Treasury at Karur Vysya Bank. “The preference for shorter bonds reflects expectations that policy rates will largely stay where they are.”
This cautious stance aligns with broader market expectations that returns in 2025 and beyond will be driven more by income than by sharp price appreciation.
Carry Trades Expected to Stay Relevant Into 2026
Looking ahead, global and domestic banks expect carry trades to remain a defining feature of India’s bond market well into 2026. With funding rates stable and short-term yields offering attractive spreads, the strategy is likely to appeal to investors seeking consistent returns in an uncertain macro environment.
“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.”
For investors, the growing popularity of short-term bonds signals a clear preference for stability, income, and risk control—hallmarks of a market preparing for modest growth rather than outsized gains.
