India's Bond Market at a Crossroads: Navigating Fiscal Pressures and Trade Tensions

India's bond market stands at a pivotal juncture, where the interplay of fiscal consolidation, trade tensions, and evolving investor preferences is reshaping the landscape for both government and corporate debt. As policymakers balance growth ambitions with fiscal discipline, and external shocks from U.S.-India trade disputes ripple through key sectors, investors face a critical decision: how to allocate capital between the safety of sovereign bonds and the higher-yielding, yet riskier, corporate paper.

Fiscal Pressures and the Government Bond Outlook

India's fiscal deficit for FY2024-25 closed at 4.8% of GDP, a marked improvement from earlier years, driven by restrained spending and a sharp contraction in capital expenditure. However, the first quarter of FY2025-26 (April-June) saw a surge in the fiscal deficit to 17.9% of the annual target, fueled by a 52% year-on-year increase in capex. This front-loading of infrastructure spending, while signaling a commitment to growth, raises questions about sustainability. The government's revised target of 4.4% of GDP for FY2026 hinges on maintaining fiscal discipline amid rising defense and capex outlays.

Government bond yields, currently at 6.38% for the 10-year benchmark, remain attractive in the APAC region, supported by the Reserve Bank of India's (RBI) 100-basis-point rate cuts in 2025. The inclusion of Indian government bonds (IGBs) in global indices like the FTSE EMGBI from September 2025 is expected to attract foreign inflows, bolstering liquidity and reducing refinancing risks. However, the government's borrowing plan for FY2025-26—Rs 14.82 trillion—includes a heavy reliance on long-term securities (30-50 years), which could expose the market to interest rate volatility if inflationary pressures resurface.

Corporate Bonds: Yield Premiums and Sector-Specific Risks

Corporate bonds have outperformed government securities in 2025, with high-rated (AAA/AA+) instruments offering yields of 7.40-7.75%, a 100-130 bps premium over G-Secs. This spread compression reflects strong demand from institutional investors seeking yield in a low-inflation environment. However, the sectoral composition of corporate debt reveals stark divergences.

Export-dependent sectors like textiles, auto components, and IT-enabled services face heightened risks due to U.S. tariffs, which have eroded margins and raised default concerns. In contrast, infrastructure, utilities, and ESG-aligned issuers are gaining traction, supported by India's capex-driven growth narrative. For instance, renewable energy bonds have attracted ESG-focused investors, offering spreads of 150-200 bps over G-Secs.

Lower-rated (BBB/BB) corporates remain under pressure, with spreads widening to 80-100 bps over government debt. Currency risks further complicate the picture for foreign investors, as the rupee's depreciation to 87.74 against the dollar in 2025 amplifies exposure.

Strategic Allocation: Balancing Yield and Risk

The key to navigating this crossroads lies in a nuanced allocation strategy that leverages the strengths of both bond types while mitigating their respective risks.

1. Government Bonds: A Pillar of Stability
2. Role in a Portfolio: Sovereign bonds should form the core of a conservative allocation, providing liquidity and downside protection. The RBI's liquidity injections and the inclusion in global indices enhance their appeal.

3. Risks to Monitor: Rising capex and defense spending could strain fiscal targets, while prolonged low interest rates may reduce returns. Investors should favor shorter-duration G-Secs to minimize refinancing risks.

4. Corporate Bonds: Yield and Selectivity

5. Opportunities: High-grade corporate bonds (AAA/AA+) in infrastructure, utilities, and ESG sectors offer attractive risk-adjusted returns. These sectors are less exposed to trade tensions and benefit from India's growth story.

6. Cautions: Avoid overexposure to export-dependent sectors. Diversify across maturities and consider hedging currency risks via forwards or non-dollar assets.

7. Active Management and Hedging

8. Currency Hedging: For foreign investors, hedging rupee exposure through forwards or gold allocations is critical. Domestic investors should monitor sectoral earnings and adjust exposure to trade-sensitive industries.
9. Duration Laddering: A mix of short- and medium-term bonds can balance yield capture with flexibility to adjust to policy shifts.

Conclusion: A Dual-Track Approach

India's bond market offers a compelling duality: the safety of government debt and the yield potential of corporate paper. However, the path to optimal returns requires a dual-track approach. Investors should anchor portfolios in high-quality government bonds while selectively allocating to corporate debt in resilient sectors. As trade tensions persist and fiscal pressures evolve, agility and sectoral diversification will be paramount.

In this environment, the mantra is clear: prioritize credit quality, hedge external risks, and align allocations with India's long-term growth narrative. The bond market's crossroads may yet prove to be a gateway for those who navigate it with foresight.