NewsRise, a financial news provider, cited an unnamed senior finance ministry official as saying the Reserve Bank of India might purchase bonds to support the borrowing programme for the next financial year and to support state-run lenders who are the market's biggest buyers.
The report sparked a sharp turnaround in a market that started the session by sliding for a second day on worries the central bank would become more hawkish on inflation, after the 2018/19 budget presented on Thursday raised spending for agriculture and lifted minimum support prices for crops.
There was no immediate comment on the report from the RBI, which holds its next policy review on Feb. 6-7.
The 10-year benchmark bond yield fell to 7.54 percent as of 0901 GMT, after rising to a two-year high of 7.68 percent.
The Indian rupee also trimmed losses to trade at 63.98/99 to the dollar from the day's low of 64.20.
India's bond market has slumped in recent months, with bond yields having risen as much as 117 points since the end of June due to concerns about rising inflation, tightening liquidity and worries about the government's fiscal deficit.
SIGNALS TO STATE BANKS ?
Traders said the report appeared to signal the government was moving towards supporting debt markets, after recent comments from Deputy Governor Viral Acharya warning about the potential losses being suffered by state-run banks in government debt.
Markets interpreted Acharya's comments as a signal to state banks to pare bond holdings.
"It is such a great news that it seems almost unbelievable," said a foreign bank trader.
A foreign bank trader said that if the central banks buys debt, it will be "great news" and "seems almost unbelievable".
"After the RBI's strong comments for the public sector banks, no one was buying bonds. Now it looks like the government is not happy with this situation," the trader said.
India on Thursday widened its fiscal deficit target for the year starting in April to 3.3 percent of gross domestic product from its previously mentioned projection of 3.0 percent.
Traders said markets were now shifting focus to the bond sale later on Friday, when the government is due to issue 110 billion rupees ($1.73 billion) in debt.