Bonds gain as Fitch upgrades rating outlook

By Subhadip Sircar

MUMBAI (Reuters) - Government bonds recouped early losses to end higher on Wednesday after Fitch Ratings upgraded India's rating outlook to "stable", a move likely to reassure foreign investors after high retail inflation and a sliding rupee pushed back hopes of a rate cut at next week's policy review.

The upgrade by Fitch also provided a much needed breather to the bond and rupee markets battered by foreign fund outflows.

Fitch has cited the measures taken by the government to contain the budget deficit, and expects it to meet the current fiscal year deficit target of 4.8 percent of the gross domestic product.

"It has come at a time when the rupee has weakened substantially and the markets have corrected drastically. Maybe for overseas investors, it would give them some confidence to stay invested here," said V. Balasubramanian, vice-president at IDBI Asset Management in Mumbai.

Yields had spiked earlier in the day after data showed on Wednesday that consumer prices remained elevated.

The annual consumer price inflation slowed for the third straight month in May to 9.31 percent, but still remains well above the central bank's comfort level.

While the Reserve Bank of India considers the wholesale price index as its main gauge of inflation, it is increasingly looking at consumer prices while setting monetary policy.

At the same time, April factory data showed that industrial output grew less than expected at 2 percent, but not slow enough to spur the RBI to cut rates on June 17.

Expectations that India may announce measures to attract foreign investment also failed to curb selling. Foreign funds have pulled out over $3 billion from the debt market in the past two weeks on the rupee's fall and rising U.S. yields.

"With revised IIP growth of March'13 coupled with higher CPI number, the probability of rate cut seems least likely on June 17 policy meet," said Shakti Satapathy, a fixed income analyst at AK Capital.

The 7.16 percent 2023 bond yield, which Reuters considers as the new 10-year benchmark, ended 1 basis point lower at 7.29 percent, snapping five sessions of gains. It had risen to 7.35 percent during the session.

Yields have risen 5 basis points so far this month as investors sharply pared expectations of a rate cut next week as a falling rupee raises concerns about inflation and the current account deficit, which the RBI has said would play a role in setting monetary policy.

India is considering simplifying the allocations of government debt limits to foreign investors, including doing away with the current system of auctions, said a source with direct knowledge of the deliberations between the government and regulators.

Interest rate swaps also eased after the Fitch decision. The longer-end five-year swap rate was unchanged at 7.03 percent. The one-year swap rate ended flat at 7.24 percent.

(Editing by Anand Basu and Jijo Jacob)