Traders will monitor the November industrial output data on Friday and December inflation on Monday for cues ahead of a critical policy review by the Reserve Bank of India on Jan. 29.
Widespread expectations the central bank will cut interest rates by at least 25 basis points has sparked the rally in debt markets, despite continued concerns about India's economic fundamentals and fiscal deficit.
Fitch Ratings reiterated on Tuesday its "negative" outlook on India's sovereign credit rating, citing concerns about slowing economic growth, persistent inflationary pressures and an uncertain fiscal outlook.
"Market has discounted a 25 bps rate cut at the upcoming policy on Jan. 29 and is looking forward for a 50 basis point rate cut in this quarter," said Kushal Maheshwari, a fund manager with Bajaj Corp., a consumer goods firm.
"We can expect the 10-year benchmark to move to 7.70 levels by March if inflation subsides, as that will augment RBI to support growth through monetary policies," Maheshwari said, adding the inflation number of Jan. 14 would be a key figure.
The 10-year yield, which had dropped to 7.87 percent, its lowest since Sept. 29, 2010 on Monday, closed up 1 basis point at 7.91 percent. The net fall in yields over the last 12 sessions now stands at 24 bps.
Traders said absence of large debt sales in the remainder of the fiscal year and active interest from foreign funds in government debt are likely to support the rally in bonds.
The government is selling only 120 billion rupees of bonds this month in the Jan. 18 week and the total supply of debt in the March quarter is limited to 600 billion rupees.
Total volumes on the central bank's electronic trading platform stood at a high 471.75 billion rupees.
Traders said investors were putting on steepener trades in the overnight indexed swap market and the negative spread between the two rates is likely to shrink to about 30 basis points heading into the policy.
The negative spread between the two rates currently stands at 39 bps. It had been at 43 bps at Monday's close.
The benchmark 5-year swap rate closed up 2 bps at 7.18 percent while the 1-year rate closed down 2 bps at 7.57 percent.
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