India’s Bond Market Will Test the RBI in 2026-27

India enters 2026-27 projecting fiscal discipline, but the bond market is already showing signs of strain. The issue is not the headline deficit number, which remains comfortably below recent peaks. The real question is whether demand will be strong enough to absorb a looming surge in bond supply without sustained central bank intervention.

The demand-supply arithmetic for the coming year is uncomfortable. Gross issuance of Indian government bonds and state government bonds is likely to exceed ₹30 trillion. That number alone would not be destabilising if traditional buyers were flush with liquidity and balance sheet capacity.

This time, they are not.

At the central government level, a fiscal deficit of around 4.2% implies borrowing needs of roughly ₹16.5 trillion, assuming nominal GDP growth of 10% in 2026–27. If about 70% of that deficit is financed through market borrowings, net issuance of Indian government bonds would be close to ₹11.5 trillion. Once redemptions of roughly ₹5.5 trillion are factored in, gross issuance rises to about ₹17 trillion.

State government borrowing adds another layer of pressure. Assuming a consolidated state fiscal deficit of around 2.8% and a high reliance on market financing, net state government bond issuance could reach ₹9.5 trillion. With redemptions of just over ₹4 trillion, gross state supply could be in the region of ₹13.5 trillion.

On paper, some offsets exist. Net Treasury bill issuance of around ₹1 trillion should be readily absorbed by banks seeking short-duration assets. National Small Savings Fund flows are likely to remain stable, given that administered rates continue to look attractive relative to bank deposits. Switches can again be ₹2.5 trillion in 2026-27 considering there are ₹6 trillion of maturities in 2027-28.

Even after accounting for these factors, the market still faces significant duration risk. The problem is that demand assumptions look fragile.

Banks are constrained. Deposit growth has lagged credit expansion, limiting balance sheet flexibility. Strong loan demand has raised the opportunity cost of holding low-yielding bonds. Even on optimistic assumptions, bank demand for Indian government and state government bonds may struggle to exceed ₹4 trillion.

Insurance companies, pension funds and provident funds remain structurally supportive, but their behaviour has changed. With yields elevated and volatility high, these investors are increasingly opportunistic rather than price insensitive. Demand of around ₹10.5 trillion from this segment is plausible, helped by gradual formalisation and labour market reforms, but it cannot be taken for granted.

Foreign portfolio inflows offer only conditional relief. India’s potential inclusion in a major global bond index could generate inflows of around ₹1.5 trillion, but the timing and certainty of that event remain unclear. Mutual funds, corporates and other investors may add another ₹2 trillion at best.

Put together, even a favourable demand scenario struggles to keep pace with the net issuance of around ₹21 trillion across Indian government and state government bonds. That leaves a residual gap of roughly ₹3 trillion. If foreign inflows disappoint or domestic investors turn more cautious, the gap widens.

Issue Management
This is where the RBI comes into play. Without outright market purchases, bond yields are likely to remain elevated through much of 2026–27. Open market operations would no longer be a discretionary liquidity management tool but a structural requirement to clear the market. Purchases of at least ₹3 trillion may be needed even in a benign scenario. In less favourable conditions, even ₹4 trillion may not be sufficient.

This does not amount to fiscal dominance, nor does it signal a shift in the monetary policy stance. It reflects a market reality. When gross supply rises faster than balance sheet capacity, the central bank becomes the buyer of last resort, whether it intends to or not.

Risks extend beyond supply arithmetic. The recommendations of the Eighth Pay Commission are expected by March 2027. Past pay commission awards have added between 0.5% and 0.8% of GDP to the fiscal deficit over time. Even if the initial impact is deferred, markets are likely to price in higher medium term borrowing needs.

State-level populism adds to the unease. A growing array of welfare schemes, particularly those targeted at women, already absorbs close to 0.8% of aggregate state GDP. Any expansion of these programmes would further strain state finances and weigh on state government bond spreads.

The yield curve is likely to reflect these pressures. The year may begin with further steepening as long-end supply dominates issuance. As liquidity tightens and rate expectations shift toward 2027–28, the curve might flatten sharply, with short-end yields drifting higher.

India’s fiscal story remains far stronger than it was a few years ago. Yet bond markets do not trade on intent alone. In 2026–27, they will test whether policy support keeps pace with supply. The answer will determine whether elevated yields become a feature rather than a phase.