Bond traders caught off-guard as talk of limited fiscal space gains ground

It’s getting hard to keep track of just what one should do with Indian bonds.

A rally Friday morning after the central bank signaled more rate cuts turned into the biggest rout in eight months after the government’s unexpected cut in corporate tax raised the specter of missing deficit targets.

Losses were pared Monday after Finance Minister Nirmala Sitharaman said the government won’t consider expanding its already record borrowings till much later. Traders though remain cautious, with Standard Chartered Plc forecasting the need for as much as 800 billion rupees ($11.3 billion) of new debt.

“Market participants were caught off-guard with the fiscal measures,” said Dhawal Dalal, chief investment officer for fixed income at Mumbai-based Edelweiss Asset Management Ltd. “Recent statements by the RBI and government officials had led to an impression that there was limited fiscal space available for large reforms.”

A gauge of volatility for India’s 10-year sovereign bonds rose to an eight-month high. 

Benchmark yields, which started Friday with a nine-basis points decline, ended the day 15 basis points higher.

They fell two basis points on Monday to 6.773%.

The unprecedented tax cut, estimated to cost 1.45 trillion rupees in lost revenue, may push up the fiscal deficit to 3.9% of gross domestic product for the year to March, compared with a goal of 3.3%, according to a Bloomberg poll of economists.

The government will announce October-March borrowing plans by month end.

A combination of additional debt sale and likely monetary easing will steepen the yield curve, Standard Chartered analysts wrote in a note. While the short end should remain anchored due to surplus liquidity and rate-cut expectations, supply will likely weigh on the long end, they wrote.

IDFC Asset Management Co. is overweight on 5-7 years bonds while cutting duration in the 10-14 year segment in its active duration funds, it said in a note.