India’s blazing bond rally collapses as fiscal worries resurface

Two months ago, it was hard to spot a bear in India’s bond market. Now, sentiment has flipped, with investors demanding higher returns to hold the nation’s debt.

That shift pushed the spread between the 10-year yield and the central bank’s policy rate to a two-year high last week. The yield now sits more than a percentage point above the policy rate. Investors expect that trend to persist, with a Bloomberg poll of 11 traders projecting the benchmark will hold near 6.5 per cent through year-end.

The market is “nervous after recent losses,” and traders are avoiding risks, said Sandeep Yadav, head of fixed income at DSP Asset Managers Pvt. Yadav said his fund is cutting longer-duration exposure.

Pension funds and insurers —  key pillars of support for the local bond market — are also turning wary. Ketan Parikh, head of fixed-income at ICICI Prudential Life Insurance Co., said that demand from the sector has slowed.

India’s debt market is sidestepping the broader emerging-market rally, where cooling inflation and steady inflows have buoyed local bonds. The selloff risks pushing up financing costs for businesses just as looming US tariffs could shave as much as 1 per cent off the nation’s gross domestic product. Rising yields also risk blunting the impact of the Reserve Bank of India’s 100 basis points of rate cuts between February and June, aiming at reviving a slowing economy.

The reversal has been swift. Losses piled up after the RBI’s cautious stance this month dimmed hopes of more easing and sent yields soaring. While a sovereign rating upgrade on Aug. 14 sparked a rally, gains vanished within hours as fiscal concerns resurfaced. 

When traders returned to their desks after an extended weekend last Monday, they unleashed the worst selloff in almost two years, spooked by fears that the government’s plan to cut consumption taxes could undermine its reputation for fiscal restraint.

Fears of a widening deficit have pushed up the benchmark yield by 18 basis points this month, with the bulk of that rise coming last week. That contrasts sharply with the first half of 2025, when yields fell nearly 45 basis points thanks to large-scale RBI bond buying. At that time, firms including Aberdeen Investments and Citigroup Inc. predicted a sustained rally. 

“It’s kind of difficult to gauge where the selloff will stop,” says Shrisha Acharya, vice president – treasury at Anand Rathi Global Finance Ltd. There are “real concerns” that New Delhi could sell additional bonds, perhaps in the range of 1 trillion rupees to 2 trillion rupees, he said. 

Still, some players, including Nomura Holdings Inc. and DBS Bank Ltd. expect the government to stick to its fiscal deficit target. Any minor slippage can be funded through short-term instruments such as treasury bills, avoiding an increase in supply of long-term bonds, Nomura economists led by Sonal Varma wrote in a note.

Despite the recent selloff, yields remain about 20 basis points lower this year.

Traders are hoping that New Delhi will cut down on long-tenor issuances, which have borne the brunt of the selling, when it unveils the fiscal second-half borrowing plan in late September.

“Long bonds could get some reprieve if the RBI adjusts the supply in long bonds in the second half borrowing program,” ICICI Prudential’s Parikh said.

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