Just a few weeks ago, the case for gilt funds, which hold government bonds with long tenures, seemed compelling.
A sharp rise in government bond yields had made valuations attractive, market sentiment had turned very pessimistic, and several fund managers argued that much of the concern around elevated borrowing and supply pressures was already priced in.
Government bond yields rose amid inflation fears stoked by the West Asia war. A rise in yield means a drop in prices, making gilt funds attractive. The market sentiment further boosted the case for gilts, with many believing that most of the concerns around elevated borrowing and supply pressures were already priced in.
Banks, flush with liquidity after the Reserve Bank of India's (RBI) open market operations, were expected to rebuild their statutory liquidity ratio (SLR) portfolios — providing a steady base of buying for government securities. SDL, or state development loan, spreads over benchmark government bonds had also widened sharply on the back of higher-than-expected state borrowings, hinting at a potential normalization trade there. This prompted several fund managers to give a tactical call on expectations of bond yields normalizing.
Then, crude upended the math
The West Asia war, now in its third month with no resolution in sight, has changed the calculus. Brent crude has surged nearly 60% since the US and Israel launched attacks on Iran in late February, and a fresh flare-up in the Strait of Hormuz on 5 May pushed prices to around $114 per barrel. India's 10-year benchmark yield rose to 7.04% the same day, while the rupee fell to ₹95.31 against the dollar, near record lows.
A 10% rise in crude oil prices is estimated to push the Consumer Price Index (CPI) up by 20 basis points, according to a 2025 paper by RBI.
For bond markets, that is a two-sided problem. Higher inflation reduces the RBI's room to cut rates; a wider current account deficit pressures the fiscal deficit, as it may mean the government needs to keep its borrowing higher. This also puts upward pressure on yields as it means higher supply of government bonds to keep up the borrowing.
Both roads lead to bond pain
"We are in the middle of a geopolitical conflict, with crude prices elevated — Brent has been above $100 — and there is uncertainty about how long this will persist. That makes it difficult to take a clear tactical view on long-duration gilt funds," said Puneet Pal, head of fixed income at PGIM India Mutual Fund.
With elections now behind India, the risk of a fuel price hike has risen. If the government passes on higher crude costs to consumers, inflation rises. If it absorbs the hit, the fiscal deficit widens. "Either way — through inflation or fiscal slippage — the macro impact is negative for long-duration bonds," Pal added.
Dhawal Dalal, chief investment officer – fixed income at Edelweiss Mutual Fund, points to compounding domestic headwinds. "Government borrowing, both central and state, is expected to remain elevated, while central bank support through bond purchases may not be as strong as last year. Foreign investor participation has also been relatively subdued this time," he said.
No clear trigger
"It is not very clear what will trigger a meaningful decline in yields in the near term. Yields may remain elevated and range-bound rather than see a sharp decline at least as things stand now," said Dalal. He recommends deploying capital gradually — in three to four tranches — rather than committing a lump sum at current levels.
"We remain neutral on the long end of the curve. The medium-term view is that yields could still edge higher," Pal said.
So investors who were looking at gilt funds as a tactical play, expecting yields to normalize in the medium-term, would be better off waiting for fresh triggers to emerge.