Tax break or not, foreign bond flows stay muted

Foreign investment in Indian government bonds is expected to remain limited in the short term, despite the removal of taxes on foreign purchases of sovereign bonds. This conclusion is drawn by SBI Funds Management in its August 2026 Market Outlook. The report cites several factors that may dampen foreign portfolio investment in Indian bonds.

These include the deferment of India's inclusion in a global bond index, global yields, domestic interest rate cycles, and expectations regarding the rupee. SBI Funds suggests that the tax relief alone may not be enough to substantially boost demand for Indian sovereign bonds. Even without taxes, the relative yield differential, combined with the current policy cycle and expectations for the Indian Rupee, do not look promising for debt flows.

Any foreign investment that does occur is expected to be tactical, guided by currency expectations. India's Reserve Bank of India is also seen as maintaining an extended pause on interest rate hikes, with any normalization of rates likely to be postponed further. The central bank's recent statements on core inflation being close to its 4% target suggests a willingness to allow headline inflation to stay above the 4% target.

This stance may also support higher global yields for an extended period. The report also highlights that global interest rates remain a significant challenge for foreign flows into Indian bonds. Weaker fiscal conditions and persistent above-target inflation in many developed economies could help keep global bond yields elevated.

Consequently, domestic interest rates may not receive much support from external flows in the near term.