Why Funds Are Cutting Hedges

Indian debt fund managers are cutting back on interest-rate hedges, especially Overnight Indexed Swap (OIS) positions. Executives at Bandhan AMC and ICICI Prudential Asset Management Co. believe these hedges are less effective now. They argue that markets have already priced in an "excessive rise" in borrowing costs, driven by increased geopolitical risks and volatile oil prices. By removing these hedges, funds that were protected from adverse rate movements are now more exposed to potential changes in monetary policy or inflation outlook. This decision is based on a view that current pricing of possible rate hikes, estimated around 50 basis points, is higher than justified, even with the Reserve Bank of India's (RBI) cautious approach.

Economic Pressures: Oil, Rupee, and Yields

This exit from hedges by large firms like Bandhan AMC and ICICI Prudential AMC comes amid significant economic challenges. India imports about 90% of its oil needs, making it highly vulnerable to inflation risks as geopolitical conflicts drive crude prices higher. This situation has already weakened the rupee, which hit record lows around 94.84 against the dollar in March 2026. Global brokerages have responded by downgrading India's economic outlook. The benchmark 10-year Indian government bond yield has experienced sharp volatility, recording its largest weekly increase in nearly four years. This was due to oil shocks, a fuel tax cut, and currency depreciation, with yields recently fluctuating between 6.68% and 6.97%. The Indian corporate bond market also faces persistent structural illiquidity, marked by few active traders and slow adoption of new regulations, which makes risk management difficult for everyone involved. Separately, ICICI Prudential AMC has a market capitalization of roughly ₹1.66 lakh crore and a P/E ratio near 50.3, while Sundaram Finance (a related company) has a P/E of about 27.14, showing diverse valuations in the financial sector. New structures like Specialised Investment Funds (SIFs) are also opening up more opportunities for strategies similar to hedge funds.

Risks of Shedding Protection

Abandoning hedges could prove to be a miscalculation, leaving debt fund portfolios highly exposed. The market is already showing caution with elevated swap rates, as the two-year OIS trades near 6%. Higher benchmark bond yields also signal that investors are demanding more compensation for risk. A prolonged surge in oil prices or incorrect inflation forecasts could push the RBI to adopt a more aggressive tightening stance, negatively impacting funds that have dropped their protections. India's vulnerability to oil price swings, coupled with structural problems like illiquidity in the corporate bond market, creates a challenging economic situation. Escalating geopolitical tensions or the breakdown of ceasefires could quickly upend the market's current optimistic view of risk. Despite strong domestic demand and growth potential in India, global factors like volatile commodity prices and currency depreciation, worsened by geopolitical issues, have led to substantial foreign portfolio investor (FPI) outflows and market drops, with the Nifty 50 seeing a significant fall in March 2026.

RBI Stance and Market Outlook

In its April 2026 policy announcement, the RBI kept the repo rate at 5.25%. The central bank noted inflation risks from rising crude oil prices but maintained a neutral stance, suggesting a focus on liquidity management rather than immediate rate increases. Analysts have differing views. Some believe a reduction in Middle East tensions could lower crude prices, possibly triggering a market recovery and boosting FPI inflows. Others anticipate the 10-year yield will stay pressured until a significant resolution is achieved in US-Iran discussions. One prominent bond fund manager, however, suggests the market is overestimating inflation risk linked to the Iran conflict, which could present buying opportunities. The future path for Indian interest rates depends heavily on geopolitical stability and ongoing inflation.