INDIA BONDS-India bonds inch up ahead of Fed meet; liquidity strains persist

By Khushi Malhotra

MUMBAI, Oct 28 (Reuters) - Indian government bonds closed slightly higher on Tuesday as traders covered short positions ahead of the U.S. Federal Reserve's policy decision, while a tight liquidity backdrop tempered risk appetite.

The yield on the benchmark 10-year note IN063335G=CC settled at 6.5357%, after ending at 6.5464% on Monday, its highest closing level in a month.

Bond yields rise when prices fall.

Investors will turn a cautious eye on the commentary in the Fed's policy decision on Wednesday, as hopes of a trade deal between the United States and China and a lack of economic data may complicate decisions on interest rate cuts in December.

Traders are also cautious as India's banking system liquidity continues to toggle between excesses and shortages, with lenders awaiting government inflows.

The banking system liquidity slipped into a deficit of 209 billion rupees ($2.38 billion) on Monday.

It was in surplus territory in the previous three days, preceded by a deficit in four earlier sessions.

"Tight liquidity is a problem...no meaningful action from the central bank has disappointed the market," Debendra Kumar Dash, senior vice president of treasury at AU Small Finance Bank, said.

Separately, foreign ownership of Indian government bonds touched a record high, with investors prizing their diversification value and potential for gains with potentially more rate cuts, even as the central bank protects the rupee.

These investors held 3.11 trillion rupees of government bonds under the Fully Accessible Route (FAR) as on October 27, accounting for approximately 6.8% of the outstanding issuance.

RATES

India's overnight index swap rates were little changed on Tuesday as traders stayed pat ahead of the Federal decision.

The one-year OIS rate INR1YMIBROIS=CC was flat at 5.4650% and the two-year OIS rate INR2YMIBROIS=CC closed at 5.4125%. The five-year swap rate INR5YMIBROIS=CC was barely changed at 5.66%.

($1 = 87.8950 Indian rupees)