India’s debt mutual fund industry is navigating one of its most volatile phases in recent years as geopolitical tensions in West Asia, elevated crude oil prices, pressure on the rupee and tightening domestic liquidity conditions reshape the fixed income outlook.
Industry experts believe the Indian debt market has entered a phase where global macro risks and domestic liquidity stress are simultaneously influencing bond yields, money market spreads and interest rate expectations.
Fund managers say the biggest trigger for markets over the past few months has been the ongoing conflict in West Asia and uncertainty around the Strait of Hormuz. The prolonged tensions have kept crude oil prices elevated above USD 100 per barrel for most of May, putting pressure on India’s current account, inflation trajectory and fiscal position.
Speaking to Cafemutual, Umesh Sharma, CIO – Fixed Income, The Wealth Company, said the recent market stress cannot be viewed only through the lens of the Gulf conflict because structural vulnerabilities had already started emerging in India’s financial system earlier, particularly on the currency front.
Unlike the 2013 taper tantrum period, when India’s current account deficit had widened sharply above 4% and debt outflows triggered a currency crisis, Sharma pointed out that the current situation is different because India’s current account deficit has remained relatively modest. Yet, the rupee has continued to face pressure due to insufficient capital inflows.
According to him, this has forced the Reserve Bank of India (RBI) to intervene heavily in the currency markets to stabilise the rupee, indirectly impacting domestic liquidity conditions.
The stress has become particularly visible in India’s money markets.
Sharma also noted that deposit growth in the banking system has not kept pace with credit growth, resulting in elevated credit-deposit ratios and forcing banks to increasingly rely on wholesale funding through certificates of deposit (CDs).
Mayur Chauhan, Fund Manager, Fixed Income, Quantum AMC, suggests that debt markets broadly priced in a “triple threat” environment during May, which include higher oil prices, rising inflation risks and rupee depreciation.
According to Chauhan, global bond yields moved higher amid persistent geopolitical uncertainty and energy supply concerns, while the Indian rupee weakened sharply and moved close to the 97/USD mark amid continued foreign outflows and rising concerns around the external sector.
He further pointed out that wholesale inflation has already started reflecting the impact of elevated energy prices, with WPI inflation rising to 8.3% year-on-year.
Jalpan Shah, Head – Fixed Income, Trust Mutual Fund, said the liquidity pressure has sharply widened spreads in money markets and corporate bonds.
“The biggest cause of concern is in the money market segment where three-month CDs are trading at nearly 200 basis points above treasury bills as banks continue to tap the wholesale market to fund high credit growth,” Shah said.
Elevated crude oil prices have complicated the inflation outlook. According to Shah, the increase in petrol and diesel prices by oil marketing companies could directly add 35-40 basis points to CPI inflation.
According to Piyush Baranwal, Director and Senior Fund Manager at WhiteOak Capital Mutual Fund, debt markets in May were largely driven by the evolving West Asia situation and its impact on crude oil, inflation expectations, currency movements and capital flows.
“Shifting expectations around a possible US-Iran agreement drove volatility across domestic bond yields, crude oil prices, US Treasury yields and the USD-INR exchange rate,” he said.
Baranwal noted that the front end of the yield curve moved higher as markets priced in an increased probability of RBI rate hikes, with the overnight indexed swap (OIS) curve implying nearly three hikes over the next 12 months. While longer-duration government bond yields initially hardened, they eased toward the end of the month as hopes of a geopolitical resolution improved.
An Axis Mutual Fund report on the debt market suggested that every USD 10 rise in crude oil prices can worsen India’s current account deficit by nearly 40-45 basis points of GDP and increase inflation by another 45-60 basis points. This underlines the economy’s structural vulnerability to oil shocks, given that India imports nearly 85% of its crude requirements.
Shah expects the Monetary Policy Committee (MPC) to prepare markets for repo rate hikes beginning August and estimates that rates could rise by nearly 75 basis points in the current cycle, taking the repo rate closer to 6%.
However, Sharma believes that the RBI is unlikely to opt for an aggressive “jumbo” rate hike similar to 2013 because the current market stress stems primarily from equity outflows rather than debt outflows.
“Ultimately, if you do a rate hike, you slow down the economy and reduce the attractiveness of domestic equity assets,” Sharma pointed out.
Chauhan believes the Indian debt market currently sits at a delicate balance between growth resilience and inflation uncertainty.
However, Chauhan believes the RBI is unlikely to raise rates immediately to defend the rupee. Instead, the central bank is expected to rely on liquidity management tools, foreign exchange intervention and calibrated communication while monitoring crude oil prices, monsoon progress, inflation trends and GDP growth data.
Baranwal echoed similar concerns, noting that while April CPI remained relatively benign at around 3.5% due to limited pass-through of fuel prices, WPI inflation surged to 8.3% from 3.9% in March, highlighting the inflation risks that could emerge if the West Asia crisis persists.
He also cautioned that El Niño risks and concerns around the monsoon could add another layer of uncertainty to the inflation outlook through food prices.
According to Axis Mutual Fund, the central bank may rely more on calibrated policy responses such as measured rate hikes of 50-75 basis points, foreign exchange intervention, NRI deposit incentives and administrative measures to attract dollar inflows, rather than resorting to emergency tightening measures like the 2013 hikes.
Recommendations
Both Sharma and Shah believe the current elevated yields and widened spreads offer attractive carry opportunities for investors willing to stay in the two-to-three-year segment of the yield curve.
“The simplest thing to do is earn the carry,” Sharma said, recommending categories such as liquid funds, ultra-short duration funds, low-duration funds and corporate bond funds in the shorter maturity bucket.
Shah similarly said that two-to-three-year corporate bonds currently offer attractive spreads over government securities along with elevated absolute yields.
However, both fund managers advised caution on long-duration strategies due to the multiple moving parts influencing the market, including geopolitical developments, inflation risks, crude oil prices and the RBI’s future policy path.
For mutual fund distributors, the message from debt fund managers remains clear — focus on accrual opportunities, maintain duration discipline and prepare investors for a prolonged period of volatility rather than expecting a quick reversal in interest rates.
Chauhan believes the current environment calls for a cautious and accrual-oriented approach rather than aggressive duration positioning.
He said the fixed income market is gradually transitioning towards a phase where carry income and volatility management become more important than duration-led gains.
According to Chauhan, Indian bond yields could stabilise in the 6.85%-7% range in the second half of the year if geopolitical tensions ease and crude oil prices soften meaningfully.
Looking further ahead, Baranwal highlighted the upcoming review of Indian government bonds for inclusion in the Bloomberg Global Aggregate Index as a key medium-term catalyst.
“If inclusion finally goes through after the previous deferral, market estimates suggest potential foreign inflows of around USD 20-25 billion over time,” he said.