After a period of strong performance, India's bond market is facing a sharp reversal, as renewed fiscal concerns and worries about government borrowing have resurfaced. This has led to investors demanding higher returns, pushing yields on government bonds to levels not seen in two years relative to the Reserve Bank of India's (RBI) policy rate.

The multi-month bull run in long-duration government bonds has hit a roadblock, with rally momentum fading as demand from key institutional investors, including banks, insurers, and pension funds, wanes. This reduced demand, coupled with fiscal concerns and diminished expectations of further interest rate cuts, has created uncertainty in the market. Since the RBI's surprising rate cut in June, the yield on the 10-year bond has increased by 24 basis points.

Several factors are contributing to this shift. Regulatory changes and evolving investment strategies are prompting banks and insurance firms to reduce their exposure to long-term bonds. An imbalance between projected borrowing and expected demand is also straining the bond market's absorption capacity. According to Axis Mutual Fund, projected borrowing is ₹11.98 trillion, while expected demand is only ₹10.82 trillion.

Fiscal pressures are also weighing on market sentiment. Slower direct tax collections and subdued nominal GDP growth are raising concerns about fiscal sustainability. Direct tax collections are down 2% from April to August 11, and nominal GDP growth is forecasted at 8-8.5%, below the budgeted 10%. However, the government is still expected to meet its fiscal deficit target of 4.4% of GDP.

Furthermore, the RBI's shift from an accommodative to a neutral stance suggests that there is limited scope for additional rate cuts. The gap between 10-year bond yields and the repo rate has widened to nearly 100 basis points.

This reversal in the bond market has implications for various stakeholders. Higher yields may attract new interest from long-term investors, but volatility remains a concern. Banks and insurers may see lower demand due to tighter regulations and less appealing spreads. Retail bond buyers may become more cautious due to diminishing returns and shift their focus to short-duration bonds. The government may face pressure on its fiscal plans and bond issuance strategy due to rising debt servicing costs. The RBI and policymakers may need to reassess their monetary and debt management tactics to stabilize the markets.

Analysts warn that if borrowing remains unchecked, long-bond yields could rise further. Concerns about the government's fiscal discipline are also making investors jittery. The proposed tax overhaul has raised fiscal deficit concerns, pushing the 10-year yield to a four-month high. While officials assure that the fiscal deficit goal remains achievable, traders fear that the tax reform could widen budget deficits and increase debt supply.