Narrow India-US Bond Yield Spread May Cap FPI Investment in Indian Bonds

Narrow India-US Bond Yield Spread May Cap FPI Investment in Indian Bonds

Introduction: The Shrinking Premium for Indian Bonds

Foreign Portfolio Investors (FPIs), who once flocked to Indian bonds enticed by high yields, are now growing increasingly cautious. The reason? A narrowing yield differential between Indian government securities (G-Secs) and US Treasuries, driven by macroeconomic shifts, central bank policies, and global inflation trends.

With the traditional “carry trade” appeal of Indian debt waning, the narrowing spread could act as a natural cap on FPI flows into Indian bonds—challenging the country’s capital mobilization strategy and reshaping foreign investor sentiment in 2025.

Understanding the Yield Spread: What’s Changed?

The India-US bond yield spread refers to the difference between the returns offered by Indian G-Secs and equivalent maturity US Treasury securities. Historically, Indian bonds offered a sizable premium—often over 500 basis points (bps)—justifying the currency and country risk for international investors.

However, as of early 2025:

• Indian 10-year G-Sec yield hovers around 7.00%

• US 10-year Treasury yield is approximately 4.60%

• The current spread stands at just 240 basis points, a sharp decline from the 350-450 bps range observed during the pandemic-era easy money cycle.

This contraction significantly reduces the risk-adjusted attractiveness of Indian sovereign debt for FPIs, especially as global interest rates rise and risk-free returns improve in developed markets.

Factors Behind the Narrowing Yield Spread

 1. Sticky Inflation in the US

Persistent inflationary pressures in the US have led the Federal Reserve to delay rate cuts or maintain higher terminal rates. This has kept US bond yields elevated longer than expected.

 2. RBI’s Dovish Tilt

In contrast, the Reserve Bank of India (RBI) has maintained a status quo on rate hikes since early 2023, and concerns over domestic growth may even prompt easing later in the year—further softening Indian yields.

 3. Global Flight to Safety

Geopolitical risks—ranging from conflicts in Eastern Europe to the South China Sea—have led to capital flight into US Treasuries, pushing yields up despite monetary tightening fatigue.

 4. Rupee Stability & Limited Depreciation Cushion

A relatively stable INR reduces currency arbitrage opportunities for FPIs, narrowing the appeal of Indian bonds as a carry trade.

How FPIs View Indian Debt in This New Landscape

Foreign investors weigh yield against liquidity, safety, and currency risk. The traditional narrative was simple: India = high yield, stable returns. But now:

• Rising global yields mean that US Treasuries offer 4.5–5% return without currency or sovereign risk.

• Indian bonds offer only 2–2.5% extra, which may not justify the rupee exposure or regulatory frictions.

• Hedging costs, especially in the non-deliverable forwards (NDF) market, further eat into the effective returns.

Hence, unless the spread widens again—either through lower US yields or higher Indian yields—FPIs are expected to turn selective in their Indian bond exposure.

FPI Investment Trends: The Recent Shift

According to latest NSDL data:

• Net FPI inflows into Indian debt stood at ₹27,000 crore in Q1 2025—down from ₹38,000 crore in Q4 2024.

• Majority of inflows are now concentrated in short-term securities, avoiding long-tenure G-Secs that are more volatile.

• Sovereign Wealth Funds (SWFs) and central banks are diversifying across Asian peers, with increased interest in Indonesian and Thai bonds.

This trend suggests profit-booking and strategic reallocation rather than long-term commitment.

Impact on Indian Debt Markets

 1. Pressure on Bond Demand

Reduced FPI interest creates excess supply in G-Secs, potentially pushing yields higher and impacting the government’s borrowing costs.

 2. Widening Fiscal Gap

Lower capital inflows may force the RBI or domestic financial institutions to absorb more debt, crowding out private lending.

 3. Index Inclusion Impact

While India’s inclusion in JP Morgan’s Government Bond Index (GBI-EM) from June 2025 is expected to bring in passive flows, these could be offset by active fund outflows due to unattractive spreads.

 4. Weakened Rupee Support

FPI debt inflows are a buffer against rupee volatility. If these inflows stagnate, it could amplify currency swings during global shocks.

What Could Reverse the Trend?

Despite the current challenges, there are scenarios under which the FPI debt appetite could revive:

 A Fed Rate Cut Cycle

If the US Federal Reserve begins easing rates in late 2025, Treasury yields would fall, making Indian bonds relatively attractive again.

 Indian Monetary Tightening (If Inflation Surges)

Any spike in inflation due to supply shocks or fiscal slippage may compel the RBI to raise rates, pushing up G-Sec yields.

 INR Depreciation with Controlled Volatility

A gradual, predictable rupee weakening can sweeten carry trade returns without adding risk.

 Regulatory Easing

SEBI or RBI introducing new norms easing FPI entry, taxation, or reporting could enhance appeal despite a narrow spread.

Expert Insights

Rajiv Kanoria, Debt Strategist, HSBC India:

"For long-term investors, the India-US spread is a critical determinant. At under 250 bps, many find it uneconomical, especially if they must hedge."

Priya Misra, Global Head of Rates Strategy, Nomura:

"Emerging market allocations are dynamic. If India's yield premium over the US doesn’t compensate for FX and credit risks, capital moves elsewhere."

Shilpa Kumar, Ex-CEO, ICICI Securities:

"The narrowing yield spread is a wake-up call for Indian policymakers. Either we make access easier or risk being bypassed."

Comparative Global Perspective: Who’s Winning the Bond Game?

India still offers a moderate yield premium, but it’s losing ground to peers with either higher yields or easier FPI frameworks.

Policy Watch: What the RBI and SEBI Are Monitoring

Both the Reserve Bank of India and SEBI are reportedly tracking FPI behavior closely. While no immediate action has been announced, a few options are on the table:

• Relaxing limits under the Fully Accessible Route (FAR)

• Allowing longer retention-free debt investments

• Adjusting capital gains tax on sovereign bond holdings

• Enhancing operational access via global custodians

The government may also consider external commercial borrowing (ECB) route recalibrations to ease pressure on the domestic debt market.

Investor Takeaways: Should FPIs Ignore India? Not Quite.

While the current environment is less than optimal for Indian bond investments, the long-term India story remains intact:

• Macroeconomic stability with controlled inflation and fiscal consolidation

• Digital public infrastructure that reduces friction and improves transparency

• Growing weight in global EM indices likely to attract steady passive flows

• Large and diverse debt market that offers scope for strategic allocation

The narrowing yield spread may delay inflows, but it doesn’t eliminate the structural appeal of India as a debt destination.

Spread Matters, But So Does Strategy

The India-US bond yield spread has always been a benchmark barometer of India’s investment allure. As that spread tightens, FPIs are forced to reconsider their allocation strategies. This doesn't signal an exodus, but rather a pause and reassessment.

For India to maintain its debt market momentum, it must pivot policy to compensate for diminishing yield appeal—either by easing market access or by enhancing sovereign credibility through reforms.

In a globalized investment world, yield is king—but ease of doing business is queen. India must play both to win.