Budget Arithmetic Leaves Bonds on Edge

Indian bond markets went into the Union Budget for 2026–27 with limited expectations, yet even those were undershot once the fiscal and borrowing numbers were laid bare. The disappointment did not stem from a reversal of consolidation, but from the absence of any upside surprise that could have eased supply concerns or anchored yields at the long end.

The government pegged debt-to-GDP at 55.6% for 2026–27, against a widely held expectation of a cleaner 55%. That gap translated into a fiscal deficit of 4.3% of GDP, marginally higher than the 4.2% most market participants had pencilled in. In absolute terms, the deficit rose 9% year on year to ₹16.97 trillion. Net market borrowing was set at ₹11.7 trillion, above expectations of around ₹11.5 trillion, while gross borrowing through dated securities came in at ₹17.2 trillion, slightly higher than consensus even after factoring in ₹1.3 trillion of treasury bill issuance.

For a bond market already grappling with supply fatigue, this was an uncomfortable signal.

Investors had hoped that 2026–27 would deliver a firmer dose of consolidation, partly because fiscal pressures loom further out. From 2027–28, the implementation of the Eighth Pay Commission is expected to lift spending on salaries and pensions meaningfully. With the award effective from January 1, 2026, arrears are likely to be paid over 2027–28 and 2028–29, complicating the debt reduction effort in those years. Against that backdrop, the relatively modest consolidation pencilled in for 2026–27 looked like a missed opportunity rather than a prudent pause.

The scale of adjustment in 2026–27 is the smallest in six years.

After deficits were compressed sharply from 9.2% of GDP in 2020–21 to an estimated 4.4% in 2025–26, the glide path now appears to be flattening. In that sense, the fiscal stance for 2026–27 is mildly expansionary, particularly given that consolidation in recent years has been more contractionary than underlying economic momentum might have warranted.

On the revenue side, assumptions were conservative. The centre’s net tax revenues were budgeted to grow by just 7.2%, while non tax revenues leaned heavily on disinvestment receipts. Estimates for collections under small savings schemes were also restrained, with growth of only 4% year on year. Expenditure numbers offered a mixed picture.

Capital expenditure was budgeted to rise 11.5%, comfortably above the assumed nominal GDP growth of 10%, though this strength was partly optical, reflecting a lower revised base for 2025–26. On current spending, the combined subsidy bill for food, fertiliser and fuel was trimmed to ₹410,495 crore from a revised ₹429,735 crore in 2025–26.

Yield Pressure
The most pressing concern for the bond market lay in interest costs. Interest payments have risen to 40% of total revenue, up from 38% in 2025–26 revised estimates, while debt servicing climbed 10.2% year on year to ₹14.2 trillion. As the policy conversation increasingly shifts from fiscal consolidation to a broader debt consolidation framework, the interest burden is becoming harder to ignore. With long-end bond yields elevated and monetary transmission still uneven, pressure is mounting on the central bank, in its role as the government’s banker, to play a more active role in containing borrowing costs.

State finances added another layer of discomfort.

 While the new Finance Commission framework comes into effect next year, the share of tax devolution has been retained at 41% of the divisible pool. Finance Commission grants to states were budgeted at ₹1.4 trillion for 2026–27, with tighter conditionality. For states already stretched by expansive welfare commitments, the absence of stronger devolution offers little respite and leaves consolidation efforts constrained.

In the near term, markets must absorb higher gross borrowing, elevated treasury bill issuance and a still unresolved overhang of state development loan supply. With the January–March quarter of 2025–26 already heavy on SDL issuance, yields remain vulnerable. The benchmark 10 year government bond appears poised to test 6.75% quickly and potentially drift towards 6.85% thereafter, unless the central bank intervenes more decisively. Even scheduled open market operations involving older securities are unlikely to distract investors from the sheer scale of supply ahead, while switch operations for the next fiscal remain capped at ₹2.5 trillion.

Attention now turns to the February monetary policy meeting and the scope for further liquidity measures. Yet the case for aggressive intervention is not straightforward. Foreign exchange intervention is expected to ease, given the impending $10 billion dollar rupee swap and existing quarter end variable rate repo liquidity of ₹1.36 trillion. Core liquidity is likely to hover around ₹6 trillion by early April, raising questions about how a large open market purchase programme could be justified without distorting system liquidity.

Looking into 2026–27, bond markets are already pencilling in OMO purchases of ₹4–5 trillion to absorb the heavy supply pipeline. Whether the central bank can credibly deliver support at that scale remains an open question. Absent a convincing backstop, yields are likely to grind higher, with the 10-year benchmark drifting towards 6.85% sooner rather than later. Sharp bear market rallies may punctuate the move, but the broader signal from this budget is unambiguous: relief for Indian bonds will be slow, uneven and increasingly dependent on monetary, rather than fiscal, support.