India-Pakistan Tensions: A Catalyst for Rising Bond Yields?

The recent military escalation between India and Pakistan, marked by cross-border strikes and escalating rhetoric, has introduced a new layer of geopolitical risk into an already fragile regional landscape. For investors, the question is clear: How will this conflict impact India’s bond market, and what does it mean for yields?

Geopolitical Tensions and Historical Precedent

The April–May 2025 conflict—triggered by a deadly militant attack in Pahalgam and India’s retaliatory Operation Sindoor—represents the most significant military exchange between the nuclear-armed rivals since 2019. Such volatility has historically spooked markets. During the 2019 Pulwama attack, Indian bond yields surged as investors fled risky assets. A similar pattern could unfold now.

The RBI’s accommodative stance—cutting the repo rate to 6% in April 蕹—aims to counterbalance global headwinds and support growth. However, the conflict adds an unpredictable variable.

The RBI’s Dilemma: Growth vs. Stability

The Reserve Bank of India (RBI) faces a balancing act. While it has prioritized growth by easing monetary policy, rising geopolitical risks threaten to undermine this strategy. Key factors to watch:

1. Fiscal Deficits and Defense Spending:
   India’s fiscal deficit target for FY2024–25 is 4.4%, but prolonged conflict could force the government to reallocate funds from capital projects to defense. Pakistan’s weaker fiscal position—foreign reserves at $16.02 billion and defense spending up 17.6%—raises the risk of regional contagion. A deeper crisis in Pakistan could destabilize trade and energy flows, indirectly pressuring Indian yields.

2. Inflation Risks:
   The RBI projects headline inflation of 4.0% for FY2025–26, within its target range. However, supply chain disruptions from the conflict—such as rerouted air traffic costing Air India ~$600 million annually—could strain prices. A weaker rupee (projected to reach 88–89 by year-end) would further amplify import costs.

3. Capital Flight and Liquidity:
   Escalating tensions could deter foreign portfolio investment (FPI). During the 2019 Pulwama attack, FPI outflows hit ₹3,000 crore. If the conflict escalates, such outflows could force the RBI to tighten liquidity, pushing yields upward.

Market Sentiment and the Bond Outlook

Investors are already pricing in risks. The 10-year Indian government bond yield has risen from 6.3% in March to 6.6% by early June 2025, reflecting growing uncertainty.

Key drivers for further upward pressure:
- Supply-Side Pressures: Increased government borrowing to fund defense and reconstruction could flood the bond market, reducing prices and raising yields.
- Rating Agency Concerns: Moody’s has warned of India’s vulnerability to geopolitical risks, which could indirectly pressure bond valuations.
- Global Spillover: A U.S.-China trade war slowdown and potential Fed rate cuts might ease some pressure, but India’s reliance on global capital markets leaves it exposed.

Conclusion: Yields Are Likely to Rise, But by How Much?

The India-Pakistan conflict has introduced a critical wildcard into bond markets. While the RBI’s accommodative policy and strong forex reserves ($686 billion) provide a buffer, prolonged tensions will likely push yields higher.

Quantifying the Risks:
- If GDP growth slips below the RBI’s 6.5% forecast, bond yields could climb to 7% by year-end.
- A 1% increase in the fiscal deficit (to 5.4%) would require the government to issue an additional ₹100,000 crore in bonds, further pressuring yields.
- A full-scale escalation, though unlikely, could trigger a 100–150 basis point rise in yields, similar to the 2019 crisis.

Investors should remain cautious. While India’s fundamentals—strong agriculture, low core inflation—offer resilience, geopolitical instability has historically outweighed these positives. The bond market is now pricing in a premium for risk, and yields are poised to reflect that reality.