Indian laborers at a construction site
Labourers stand on a winch of a crane at a construction site on the outskirts of New DelhiReuters

Financial experts believe that Indian bond yields are unlikely to spike if the Union Budget 2015 opts for increased infrastructure spending while allowing the fiscal deficit to widen a bit and adopting the necessary fiscal consolidation.

Bond yield is the return, an investor receives for investing in a bond, calculated using the formula: yield = coupon amount(Interest)/price.

When a bond is priced at par, its yield is equal to its interest rate. Bond yields move inversely with bond prices.

Finance Minister Arun Jaitley wants to limit the fiscal deficit to 3.6% of the GDP in the upcoming fiscal -- an eight-year low -- a move that government economic advisors argue against. Instead, they recommend for the fiscal deficit to climb to as much as 4% of the GDP, backed by government increasing capital spending to help the economy break free from the slowest economic growth phase since the 1980s.

Cutting back on subsidies and bringing in key tax reforms is also expected to improve government revenue.

The Reserve Bank of India has also called on the government to undertake the necessary fiscal consolidation reforms if the interest rate is set to go down.

Investor Sentiment

As long as the source of revenue is mentioned and a roadmap for its deployment is made, a realistic deficit target can be factored in and "the market may give it a pass," Killol Pandya, Senior Debt Manager with LIC Nomura Mutual Fund told Reuters.

However, he warned that an overtly optimistic deficit estimate could lead to a sell-off.

The RBI reconvenes on 3 February, with the market and the government hoping for a rate cut. The banking rate has remained stable at 8% since January 2014, as inflation has also remained high except for the last few months of 2014.

On Tuesday, the benchmark 10-year bond prices climbed to a 18-month high, on the back of lower-than-expected inflation figures, fuelling further speculation of a rate cut.

Investors in the debt market would be willing to cut the government some slack on the deficit, if the increase in spending correlates to a list of pending reforms – developing infrastructure to support the manufacturing sector, banking reforms, housing projects, etc.

In July 2014, on the back of the NDA government deciding to stick to the UPA government's budget deficit of 4.1% of GDP, bonds prices fell sharply as investors doubted the government's ability to pull it off.

"The quality of spending is important," said Kumar Rachapudi, a fixed income strategist for ANZ in Singapore. "If there are clear projects, say infrastructure creation, for which spending is earmarked, then markets may take it a bit positively."

All stakeholders agree that any spending increase needs to be accompanied by a plan to rein in expenses, notably on food and fuel subsidies, which consume a substantial portion of government spending.

Credit Rating

India's credit rating by Standard & Poor's stands just a notch above junk bond. The ratings firm wants the NDA government to adopt a goods and services tax, which would standardise all inter-state movements and reduce subsidies, which amount to almost 2% of the GDP.

India's credibility on fiscal deficit target has taken a serious hit, with the former UPA government setting unrealistic numbers and then trying to adjust it over the course of the year.

Even with extra leeway, the government would want to assert its commitment to sticking to the deficit target, noted Arvind Chari, head of fixed income and alternatives at Quantum Advisors.

"If they are deviating from the roadmap, it would be imperative to tell the market why and how they plan to get back on track," he added.