Why the bond market is unfazed by a 22-year-low yield gap

Bond yields in the two countries are now at their closest in 22 years due to the combined effect of the Trump tariffs and a rating downgrade in the US and rate cuts and low inflation in India. However, domestic macro stability is expected to shield India from any major outflows, experts said.

The US 10-year Treasury yield stood at 4.55% on 19 May as compared to 6.28% for the Indian counterpart, Bloomberg data showed, a gap of 173 bps. This is the smallest such gap since 15 July 2003, when the US yield stood at 3.98% and the Indian yield at 5.71%.

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In the last one year, the yield differential has reduced by 93 bps. The average differential during the last 22 years was 418 bps.

“The yield spread had narrowed from as much as 500 bps three years ago to 173 bps currently, led by India's relatively stronger macroeconomic fundamentals versus US macro, which is why we haven't seen huge debt outflows by FPIs," said Deepak Agrawal, chief investment officer (debt), Kotak Mahindra AMC. “To my mind, if the spread compression is macro-led and gradual, we will not see any disruption going forward," said Agrawal.

Typically, when the yield gap shrinks, foreign portfolio investors sell Indian bonds and invest in US bonds for risk-free returns. However, in recent years, India's sharply improving fiscal deficit and slowing inflation meant that Indian bond yields stayed stable while US yields spiked. A fall in bond yields results in a rally in bond prices.

 

This was amply clear in foreign portfolio investment (FPI) activity in Indian bonds after 2022, which saw outflows of $2 billion. In 2023, the FPIs net purchased Indian bonds worth $8.29 billion and the next year, a whopping $13.3 billion. This was the highest since 2017 when inflows stood at $23 billion, as per National Securities Depository Limited data.

Debt market experts said the differential may remain compressed in the short term because of the uncertainty on tariffs, but there is little to worry given India's sound macroeconomic fundamentals.

That is till 8 July, when the 90-day pause in US reciprocal tariffs ends. US President Donald Trump came to power promising stiff tariffs on friends and foes, plans to revive industrial jobs and a loose fiscal policy. He took office on 20 January. In April, Trump announced reciprocal tariffs on a host of nations, only to announce a three-month pause soon after.

To be sure, the spike in US bond yields in 2025 has resulted in FPI outflows worth $2.3 billion as the yield swung between a high of 4.79% on 14 January and a low of 3.99% on 4 April, after which it has climbed to 4.46-4.5% currently, thanks to the reciprocal tariff proposal.

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“If there are deals, like with China and possibly EU, US yields would fall as concerns over inflation would abate, and this would widen the spread between US and India 10-year paper," said Madan Sabnavis, chief economist, Bank of Baroda.

On 16 May, Moody's Ratings downgraded the US government’s long-term issuer and senior unsecured ratings by one notch to Aa1 from Aaa and changed the outlook to stable from negative. Following this, the 30-year US treasury yield hit an 18-month high before retracing those levels, Reuters reported on 19 May.

“India was never really a debt market that attracted overseas investors, as compared to our equities," said Jayesh Mehta, vice-chairman and chief executive, DSP Finance. Mehta said the bond market in India was always driven by more local demand, but now, there is some more demand because of inclusion in the indices.

Indian government bonds were included in the JPMorgan Emerging Market Global Diversified Bond Index in June last year and Bloomberg’s emerging market bond index in January under the fully accessible route (FAR), which allows unrestricted investments.

The securities will also be added to the $4.7 trillion FTSE Emerging Markets Government Bond Index in September this year. The inclusions were supposed to attract about $22 billion between June 2024 and April 2025. However, foreign investors have put in around $12 billion through the FAR during the period.

“Our inflation is quite stable right now, and also, the outlook on USD-INR is positive, so at some point, the yield differential has to narrow because of the strength of the Indian economy," said Mehta.

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India’s inflation measured on the consumer price index (CPI) eased in April to its slowest in over six years and well within the Reserve Bank of India's (RBI) flexible inflation target of 2-6%. Retail inflation stood at 3.16% year-on-year in April, down from 3.34% in March, 3.61% in February, and 4.83% in the same month last year.

A senior executive at a foreign bank said that it is unlikely that there is a risk of any major outflows from the debt markets. “Taking out money and the consequent forex conversion is too much of an effort. The investments into debt, especially the passive flows into indices, in India are by long-term investors who can withstand such fluctuations," the banker said on the condition of anonymity.

One thing experts like Kotak Mahindra's Agrawal cite is the higher real rate of interest in India versus that in the US, which will temper outflows. “Let’s consider the midpoint of the US 10-year at 4.35% and average inflation at 2.8% this year, while that of India at 6% and average inflation for FY26 at 3.7-3.8%. Now, if RBI were to cut the repo rate by another 50 bps, Indian yields would still be above the US in real interest rate terms, which would not rock the boat," Agrawal said.