Note to fixed income investors – Dec 2025

As per the consensus view, the MPC has unanimously decided to reduce the policy rate by 25 bps to 5.25%, after the pause in the last two meetings. Accordingly, the Standing Deposit Facility (SDF) rate has been brought down to 5.00%, and the Marginal Standing Facility (MSF) rate and the Bank Rate to 5.50%. The MPC also decided to continue with the neutral stance. This takes cumulative easing to 125 bps in 2025, amid a rare mix of sturdy growth and historically low inflation.

While liquidity has moderated since the measures announced in the June policy, system liquidity remains comfortable. Since the last MPC meeting in October, banking system liquidity has averaged a surplus of INR 1.5 lakh crore (down from ~INR 2.1 lakh crore in the Aug-Oct period). Transmission of these cuts has been broad-based across sectors. To further support liquidity and monetary transmission, the RBI announced Open Market Operation (OMO) purchases of ₹1 lakh crore and a three-year USD/INR buy–sell swap of $5 billion during December. These measures solely aim to support liquidity, including offsetting drains from recent forex interventions, without the intention of supporting the INR, as per the RBI Governor.

Inflation came in much lower than the MPC’s projections, at CPI of 0.25% in October, driven primarily by reduction in food prices (food group deflation of -3.7% YoY), while also being supported by the GST rationalization. Further, the inflation outlook also appears benign, due to higher kharif production, healthy rabi sowing and adequate reservoir levels. Moreover, barring a drop seen in some high frequency indicators, domestic growth remains broadly robust, with the RBI revising its FY26 GDP growth forecast upward to 7.3% from 6.8%, supported by healthy agricultural prospects, GST rationalisation, benign inflation, and healthy balance sheets of corporates.

In a shift in the market expectation versus the previous policy, the MPC commentary suggests an accommodative tilt, given low expected inflation, and potential softening of growth, spurred by global demand uncertainties, including tariff policy shifts and risk-off sentiment due to prolonged geopolitical tensions.

The bond market reacted positively to the policy announcement, with the 10-year G-sec yield settling at 6.48%, a 5 bps drop versus the previous close. It continues to trade within a narrow band of 6.46%-6.56%. Lately, short-term rates have moderated significantly, supported by rate cuts and surplus banking system liquidity. The term spread between the 3-month T-bill and the 10-year G-sec is now ~110 bps, close to the long-term average of ~120 bps. In the near term, the 10-year G-sec is expected to remain range-bound in the absence of any adverse developments.

Strategy for Fixed Income Investors

With the decline in G-sec yields over the past twenty months, our overweight stance on duration has played out well. As highlighted in previous notes, we shifted to a neutral stance and continue to expect limited capital gains from further rate declines. Long-term yields may remain sensitive to evolving growth-inflation dynamics.
Corporate bond spreads remain muted, with AAA spreads still below long-term averages due to limited supply. In select cases, AA and A-rated bonds offer attractive spreads after adjusting for risk. Investors with a higher risk appetite may consider evaluating select high-yield strategies.

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