Indian government bonds experienced a notable decline in early trading on Wednesday following the Reserve Bank of India's decision to focus on illiquid securities for its upcoming debt purchase operation. The move has left market participants questioning the central bank's strategy as it sidesteps market demand for liquid note inclusion.

Bond Market Performance

The benchmark 10-year government bond yield demonstrated the market's reaction to the RBI's announcement:

Bond yields move inversely to prices, meaning the increase in yield reflects falling bond prices across the market.

RBI's Security Selection Strategy

The Reserve Bank of India's latest debt purchase operation will target bonds worth ₹50,000 crores, equivalent to $5.55 billion. However, the selection criteria have raised concerns among market participants:

• Maturity range: Securities maturing between 2029 to 2053
• Liquidity status: All selected notes are illiquid and infrequently traded
• Market expectation: Traders anticipated inclusion of the liquid 6.33% 2035 bond
• Consecutive pattern: Second week of avoiding liquid papers in open market operations

"For the second consecutive week, the RBI has been falling short of market expectations leaving us puzzled as to what could be the reason for not giving the 6.33% 2035 bond in OMO," commented a trader from a primary dealership.

Market Concerns and Implications

Traders have expressed significant concerns about the sustainability of bond market rallies under the current approach. The focus on illiquid papers means funds invested in liquid securities remain tied up, potentially limiting market momentum. This concern becomes particularly relevant given the substantial debt issuance pipeline ahead.

Upcoming Debt Supply Challenges

The massive debt supply from both state and central governments has created investor concerns about deteriorating demand-supply dynamics in the bond market.

Interest Rate Environment

India's overnight index swap rates are expected to remain range-bound during the current session due to lack of market triggers:

• Five-year OIS rate: 5.95% (little changed)
• One-year and two-year OIS rates: Not yet traded
• Market outlook: Thin trading range anticipated

The bond market entered 2026 with uncertainty surrounding investor appetite for increased debt supply, despite the RBI's continued support through regular bond purchase operations. The central bank's strategy of focusing on illiquid securities while maintaining substantial purchase volumes reflects a complex balancing act between market support and operational objectives.

The Reserve Bank of India has proposed significant changes to dividend payout norms for banks, introducing a graded structure based on capital adequacy levels. Under the draft Commercial Banks – Prudential Norms on Declaration of Dividend and Remittance of Profits Directions, 2026, the regulator has raised the dividend payout cap for banks to 75% of net profit from the earlier 40% rule, with implementation scheduled for financial year 2026-27.

Graded Structure Based on CET1 Capital Levels

The RBI has introduced a comprehensive graded framework linking dividend payouts to Common Equity Tier 1 (CET1) capital ratios. Stronger banks with more than 20% CET1 would be allowed to pay 100% of adjusted net profit, which is calculated as net profit minus net non-performing assets for the dividend payment year. However, this remains subject to the overall 75% dividend payout limit.

Special Requirements for Systemically Important Banks

Systemically important banks face even stricter capital requirements for maximum dividend payouts. State Bank of India would need a minimum 20.80% CET1 ratio to pay 100% dividend of adjusted net profit, while HDFC Bank and ICICI Bank would require minimum CET1 ratios of 20.40% and 20.20% respectively.

Enhanced Oversight and Eligibility Criteria

The central bank has established specific conditions that banks must meet before declaring dividends. Bank boards are required to oversee asset quality and provisioning gaps, capital projection and long-term growth plans before declaring dividends. Banks must maintain positive adjusted profit after tax for the period for which dividend is proposed and meet minimum capital adequacy norms.

The regulatory framework establishes differentiated payout limits based on bank categories, with regional rural banks and local area banks facing a higher cap of 80% of profit after tax compared to the 75% limit for commercial banks.

Foreign Banks and Compliance Measures

Foreign banks operating in India through branch mode can remit dividends or surplus without prior RBI approval. However, if excess remittance is found on audit, the head office must return the excess remittance and make good the shortfall. For all banks, any exceptional or extraordinary income, or profit overstatement identified in statutory auditor reports with modified opinions, shall be deducted from net profit calculations.

Public Consultation and Implementation

Stakeholders can submit comments on the draft directions until February 5 through the 'Connect2Regulate' section on the RBI's official website. The comprehensive review reflects the RBI's ongoing efforts to align prudential norms with evolving banking practices while maintaining appropriate regulatory oversight of dividend policies across different categories of banking institutions operating in India.