India’s bond market is entering a more complex phase as rising crude oil prices, geopolitical uncertainty and inflation concerns reshape expectations around interest rates. Yet, despite the challenging backdrop, Axis Mutual Fund believes investors should resist the temptation to turn defensive and instead use periods of volatility to gradually build exposure to longer-duration fixed-income assets.
The fund house’s latest fixed-income strategy note comes at a time when bond markets are trying to assess the implications of developments in the Middle East and their impact on inflation, growth and monetary policy. While oil prices remain elevated, recent hopes of a peace deal between the United States and Iran have provided some relief.
Indian bonds this week
Indian ended the week on a strong note, with benchmark yields posting their biggest weekly decline in seven weeks after crude oil prices fell sharply on expectations of progress in ceasefire negotiations. The benchmark 6.48% 2035 government bond yield closed at 7.0037% compared with 6.9960% on Wednesday. The 10-year yield recorded its largest weekly decline since April 10, falling 8.8 basis points.
futures declined around 10% during the week and were trading near $93 per barrel after reports that the US and Iran had agreed to extend their ceasefire by 60 days. Meanwhile, the US 10-year Treasury yield eased to 4.44%, down more than 13 basis points for the week. Lower crude prices are particularly important for India, which imports nearly 90% of its oil requirements, as softer energy prices can help contain inflation, support the rupee and ease fiscal pressures.
Why Axis MF believes investors should not abandon duration
Despite the recent relief in oil prices, Axis Mutual Fund warned that India is moving into what it described as a “materially different macro regime” compared with previous oil-driven stress periods such as 2013, 2018 and 2022. According to the fund house, the combination of elevated crude prices and geopolitical tensions is creating simultaneous pressure on inflation, economic growth, the rupee and government finances.
India’s vulnerability stems from its dependence on imported energy. Axis MF estimates that every $10 increase in crude oil prices can widen the current account deficit by 40-45 basis points of GDP, increase inflation by 45-60 basis points and add to fiscal pressure if the government chooses to reduce fuel taxes to absorb part of the shock.
However, the fund house believes the current situation differs from earlier crises because India enters this period from a position of greater strength.
“Yet, unlike earlier cycles, India entered this phase from a position of relative strength, supported by lower private leverage, healthier banks, stronger foreign exchange reserves, improved fiscal credibility, global bond index inclusion, and deeper domestic financial savings,” Axis MF said.
Against this backdrop, Axis MF recommends that investors continue allocating to fixed-income assets, albeit gradually.
“Investors could buy fixed income assets, but gradually,” the fund house said.
The report further argues that markets may be overestimating how aggressively the will need to respond. According to Axis MF, overnight indexed swap markets are currently pricing in nearly 75-100 basis points of rate hikes, while government securities, corporate bonds and money markets are all reflecting expectations of tighter liquidity and higher borrowing costs.
The fund house believes such expectations may be excessive. Its base-case scenario is that the RBI is unlikely to repeat the aggressive tightening cycle seen during the 2013 “Taper Tantrum.” Instead, the central bank could rely on a broader toolkit that includes measured rate increases of around 25-75 basis points, liquidity management measures, foreign exchange intervention and policies designed to attract dollar inflows.
Axis MF also cautioned that aggressively raising rates may not solve the underlying challenge.
“INR depreciation cannot be solved purely via rate hikes. Aggressive hikes may damage growth trajectory for India as oil shock is supply-side, not demand-side. Thus, higher rates may weaken growth without materially stabilizing INR,” the report said.
While Axis MF remains tactically positive on duration, it is not advocating an aggressive long-duration stance. The fund house warned that India may be moving away from a “Goldilocks” environment characterised by low oil prices, benign inflation and stable fiscal conditions.
Axis MF recommends maintaining a neutral-to-slightly long duration position over the next three months, adding more duration after the first RBI policy response over the following three to six months, and extending duration further over six to twelve months if crude prices fall below $75 per barrel or if long-term bond yields rise above 7.9%.
With the RBI’s policy decision due on June 5, bond investors will be closely watching whether the central bank validates market fears or supports Axis MF’s view that markets have become overly pessimistic.
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