The Union Budget 2026 has proposed to make it easier to trade corporate bonds, introduce new risk management tools, and encourage large municipal bond issuances. It also proposes to restructure the Power Finance Corporation and the Rural Electrification Corporation.
While the exact nature of these proposals remain unclear, the foundations of bond markets must be fixed first. This includes credible pricing of government debt through a yield curve that is truly market driven, clearer commercial mandates for PFC and REC, integrated trading between government and corporate debt, and transparent municipal finances. Without these, the Budget 2026’s measures risk remaining well-intentioned signals rather than drivers of growth.
Corporate bond market, and REC-PFC
India’s corporate bond markets have grown quite rapidly in the last ten years. As of March 2025, it had touched Rs 53 lakh crore (about $600 million), and yet, this constitutes only about 10-15 per cent of total corporate debt in India. Firms continue to rely more on bank credit for their investment needs.
Why have our corporate bond markets never really taken off? The government is the largest borrower in the economy, and considered the safest. Therefore, the interest rate on government bonds (the risk-free rate) is the starting point to price all other loans. Corporate bonds are priced as a spread over the risk-free rate. In India, the reference risk-free rate is unreliable as large institutions are mandated to buy and hold government bonds. With forced buying, yields no longer fully reflect the fundamentals such as fiscal risk, and inflation expectations. Institutions such as the REC and PFC are treated as near-sovereign despite near-bankrupt state distribution companies being one of their largest borrowers. This distorts the structure of interest rate further, as their bonds fall between government debt and private corporate credit.
Regulations ensure that investors are restricted to conservative mandates such as AAA or AA rated paper. Government bonds and corporate bonds are traded in different places. Government bonds mainly trade on a specialised platform run under the Reserve Bank of India’s oversight, which is used mostly by banks and large financial institutions. Corporate bonds, on the other hand, are traded on stock exchange platforms that are more familiar to equity investors. Traders and investors cannot easily move between these markets.
As a result, the risk-free rate does not convey true information. There is considerable illiquidity in several maturity buckets, and limited demand for the bonds of lower-rated but economically viable firms. Prices in one market do not quickly influence prices in the other, reducing trading activity, and making it harder to compare risks across different bonds, further slowing down price discovery. Index market making and total return swaps as proposed by the budget could help solve the liquidity problem to some extent. However, these measures depend on a trustworthy benchmark curve, which continues to elude our markets.
Municipal bonds
India’s urban infrastructure such as roads, sewage, water, and transport require large-scale investments. Most of this financing today comes from the Budget. An alternative financing mechanism is to raise bonds and spread the cost over time. Since FY2018, urban local bodies have raised between Rs 2,000-3,000 crore through bond issuances. But this activity has been restricted to only about 19 out of the 269 municipal corporations, and constitutes less than 1 per cent of the overall public sector debt.
The government appears to want to jump-start the municipal bond market with its proposal to offer a Rs 100 crore incentive for issuances exceeding Rs 1,000 crore. The fundamental problem, however, is the fiscal (ill)health of the urban bodies. Most of these have opaque non-standardised accounting, and uncertain revenue streams. Property taxes, user charges, and intergovernmental transfers can become political issues, and are often not enforced. Investors, therefore, struggle to assess credit risk or repayment capacity. Further, a threshold of Rs 1,000 crore implies that only a few large cities might be able to utilise the incentives. It is quite likely that these cities already have access to funding from the state or central government. The question remains: how will municipalities generate predictable cash flows to service debt?
Roadmap for implementation
Firms need long-term funding to make investments while municipalities or urban local bodies require financing to provide urban services. In most advanced economies, such finance is provided by bond markets as banks are ill-suited to provide long-term credit. Getting bond markets right is important for economic growth.
A genuinely market-determined government yield curve is a prerequisite for bond market deepening and development. This requires reducing financial repression through lowering mandates on financial institutions to purchase and hold government bonds. The reform of REC and PFC through clearer commercial mandates would allow their bonds to be priced on economic fundamentals. Integration of government and corporate bond trading on a single venue would deepen secondary market liquidity.
For municipal bonds, the core reform should be of cleaning up their balance sheets, providing standardised accounts, and audited disclosures. Local bodies also need to work on strengthening their own-source revenue to signal an ability-to-repay, while the government needs to build clear bankruptcy or resolution frameworks.
Only with these institutional foundations can Budget 2026’s announcements deliver meaningful and lasting impact.
Renuka Sane is managing director at TrustBridge, which works on improving the rule of law for better economic outcomes for India. She tweets @resanering. Views are personal.
(Edited by Prashant Dixit)