India's recent inflation data, particularly the easing of the Consumer Price Index (CPI) to 1.54% in September 2025, has emerged as a significant factor influencing the country's financial landscape. The consistent fall in inflation, driven primarily by fall in food prices, has fallen comfortably below the Reserve Bank of India's (RBI) upper tolerance limit and, at times, even below the central bank's medium-term target of 4%. This development has created a notable "sweet spot" for the secondary bond market.
The Inverse Relationship: Inflation, Interest Rates, and Bond Yields
To understand the effect on bonds, one must grasp the inverse relationship between bond prices and their yields (or interest rates).
• Bond Prices and Yields: When market interest rates rise, the price of existing bonds (which offer a fixed, lower coupon rate) falls in the secondary market to make their effective yield competitive with newer, higher-rate bonds. Conversely, when market interest rates fall, the price of existing bonds rises.
• Inflation and Interest Rates: Inflation is a bond's worst enemy because it erodes the real value (purchasing power) of a bond's fixed future interest and principal payments. Historically, central banks, like the RBI, raise their key policy rates (like the Repo Rate) to combat rising inflation.7 A fall in inflation, therefore, reduces the pressure on the central bank to keep interest rates high.
Effect on Secondary Bond Market Rates (Yields)
The falling inflation in India has had a distinctly bullish impact on the secondary bond market, mainly by lowering interest rate expectations.
1. Reduced Expectation of Rate Hikes
A lower and stable inflation reading gives the RBI the policy space to maintain an accommodative or neutral stance, and potentially to cut the benchmark Repo Rate. Since the RBI’s policy rate directly influences lending rates and the overall cost of money in the economy, a lower anticipated Repo Rate immediately translates to lower yields on Government Securities (G-Secs) and corporate bonds in the secondary market.
2. Bullish Trend: Falling Yields and Rising Prices
When bond yields drop in anticipation of or following an RBI rate cut:
• Bond Prices Rise: The price of existing bonds in the secondary market moves up. This offers capital appreciation to bondholders, especially those holding longer-duration bonds, which are more sensitive to interest rate changes.
• Lower Cost of Borrowing: For the government and corporations, lower G-Sec and corporate bond yields mean a reduced cost of future borrowing. This is beneficial for fiscal management and capital expenditure.
3. Favourable Real Returns
Falling inflation increases the real return for investors. A bond with a 6% nominal yield becomes much more attractive if inflation falls to 2% (a real return of 4%) than if inflation was 5% (a real return of 1%). This higher real return attracts more investors, increasing demand for bonds and further pushing their prices up (and yields down).
4. Impact on the Benchmark 10-Year G-Sec Yield
The yield on the benchmark 10-year Government Security (G-Sec) is the most-watched metric in the Indian bond market. Recent trends show that as inflation has fallen below the RBI's comfort zone, the 10-year G-Sec yield has typically shown a downward bias (meaning its price is rising), reacting positively to the dovish outlook on interest rates.
Conclusion
The sustained moderation in Indian inflation has been a significant tailwind for the secondary bond market. It reinforces the expectation of a "lower for longer" interest rate environment, which translates to a fall in bond yields and a corresponding rise in bond prices. While global factors and the government's borrowing programme still influence market sentiment, the benign domestic inflation picture provides the crucial foundation for a positive outlook for fixed-income investors in India.
Reference used: https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR490F9F47F74F55146D48D4F15690DE513AE.PDF
