INDIA BONDS-India bonds up on state supply cut, Index entry buzz

By Khushi Malhotra

MUMBAI, Jan 12 (Reuters) - Indian government bonds surged on Monday, with the 10-year yield posting its sharpest decline in nearly three weeks after states cut this week's auction size and as investors speculated about a potential entry into the Bloomberg Global Aggregate Index.

The benchmark 10-year bond IN064835G=CC yield settled at 6.6050%, versus Friday's close of 6.6401%, the steepest one-day drop since December 24.

Bond yields rise when prices fall.

States will borrow up to 268.15 billion rupees ($2.97 billion) on Tuesday, below the scheduled 362 billion rupees.

Traders welcomed the reduced auction as a widening supply-demand gap has been a persistent source of market worry, with combined state and the central government issuance set to hit a record 8 trillion rupees this quarter.

"The rally was largely driven by the states' supply cut and the Reserve Bank of India's open market purchase, while some flows may have come in anticipation of index inclusion," said Debendra Kumar Dash, senior vice president of treasury at AU Small Finance Bank.

Traders are keenly tracking news on the possible inclusion of India's fully accessible route (FAR) bonds in Bloomberg's bond index, which could go some way to allaying demand-supply gap fears.

Other factors supporting bond bulls include the RBI's purchase of bonds worth 500 billion rupees earlier in the day and data on India's retail inflation INCPIY=ECI that came in at 1.33% in December, below the central bank's target.

Gains may be contained though on uncertainty stemming from the escalating tension between the U.S. Federal Reserve and President Donald Trump.

RATES

India's overnight index swap curve flattened, with long-end rates easing along with bond yields.

The one-year OIS INR1YMIBROIS=CC ended at 5.4875%, while the two-year OIS rate fell 1.25 bps to 5.5750%. The liquid five-year OIS rate INR5YMIBROIS=CC dipped nearly 2 bps to 5.9350%.

($1 = 90.1810 Indian rupees)