Traders said hopes New Delhi could raise the ceiling on foreign institutional investment in government debt from $10 billion now was a positive for bonds, but the rates outlook and upcoming supplies kept the market in a tight range.
A senior finance ministry source told Reuters on Monday the government was considering the proposal.
10-year benchmark yield was at 8.76 percent, 1 basis point above Monday's close, after trading in a range of 8.73 to 8.77 percent.
Total volume on the central bank's electronic trading platform was moderate at 38.85 billion rupees ($791 million).
"There is a bit of cautious optimism being seen in the market. Rate hike is already priced in, but supply is what is spooking," said Prasanna Patankar, senior vice president at STCI Primary Dealer.
"People want to avoid building too many positions ahead of the policy, especially with a 150 billion rupees sale lined-up immediately after it."
The Reserve Bank of India (RBI), which has raised rates a dozen times since mid-March 2010, is set to review policy on Oct. 25 and the possibility of another increase has gained momentum after inflation remained high in September.
The 10-year yield is seen in a broad 8.70 to 8.90 percent band until the policy.
Patankar said banks were unwilling to buy on expectations the 10-year yield could top 9 percent in a month's time.
The 10-year yield had risen to 8.85 percent during trade on Monday, its highest since Aug. 28, 2008, but came off on the possible increase in limit for foreign fund investment and comments by the German finance minister on the euro zone debt.
Asian stocks and commodities fell on Tuesday after Germany's finance minister cautioned against hopes for a quick fix to Europe's debt problem, and news that China's economic growth slowed a tad in the third quarter added to concerns.
The benchmark five-year swap was at 7.40 percent from 7.43 percent on Monday and the one-year rate was 2 bps higher at 8.22 percent.
OPEN MARKET OPERATIONS
The market has been waiting for the RBI to announce open market operations for buying bonds in an attempt to alleviate the huge supply pressure following an increase in borrowing.
The government last month set market borrowing of 2.2 trillion rupees in the second half of the fiscal year starting October, sharply above the budgeted 1.67 trillion rupees.
"Only open market operations by RBI or a change in the central bank's policy stance can prevent a sharp rise in yields," a senior dealer with a foreign bank said.
The RBI had last bought 370.68 billion rupees of bonds under its open market operations during December and January to help ease a cash crunch with banks.
The central bank has since refrained from conducting OMOs as the move injects liquidity which is in conflict with its anti-inflationary stance.
"Last year, when the central bank did open market operations, the liquidity situation was much worse. So far liquidity has been in a range, so possibly the central bank may wait a while before conducting OMOs," another senior dealer with a private bank said.
Copyright Reuters, 2011