Bonds extended a rally which began on Monday on growing hopes that the government's increasing thriftiness will help prevent any additional borrowing via bonds, and any excess borrowing will be limited to shorter-dated treasury bills.

After trading hours on Monday, the central bank said a federal bond auction for 120 billion rupees ($2.18 billion) scheduled in the week ending Jan. 4 has been moved to the week ending Feb. 22.

The RBI also said it will buy up to 80 billion rupees of bonds via open market operations, its fifth such purchase since it resumed OMOs in early December.

"Bonds are in a sweet spot. Postponement of the auction, continuing OMOs, big buying from provident funds from SDL (state development loans) interest and expectations of rate cut in January are fuelling the current rally," said B. Prasanna, chief executive at ICICI Securities Primary Dealership.

He expects the 10-year yield to touch 7.80-7.90 percent levels during the current quarter.

The 10-year yield ended at 7.99 percent, down 6 basis points from Monday's close and below the RBI's repo rate of 8 percent.

It fell to a low of 7.90 percent in early trade, as per data from the central bank's trading platform, which makes it a two-year low for the benchmark paper, but dealers said there was a single outlying trade executed at that level.

Volumes were heavy at 439.40 billion rupees ($8.02 billion) on the first trading day of the new year.

Bonds are widely expected to rally in early 2013 as the central bank is expected to cut interest rates as early as January and buy more bonds to ease a continued cash crunch in the banking system.

Higher investment limits in local bonds for foreigners is also expected to give a further fillip.

The government is also aiming to curb its expenditure, with global rating agencies and investors putting pressure on New Delhi to shore up its finances.

The federal government's cash balance with the central bank rose to 9 billion rupees on Dec. 21 as against 1.84 billion rupees in the previous week, a sign the government is holding back on spending.

Interest rate swaps also eased in line with bond yields.

India's short-end 1-year rate fell to a two-month low in session, before ending at 7.59 percent, down 1 basis point. The long-end 5-year OIS rate was down 2 basis points at 7.10 percent.