Indian government bonds ended largely unchanged Wednesday, with the benchmark 10-year yield settling at 6.61% compared to the previous session's close of 6.61%. The flat performance followed disappointment over the Reserve Bank of India's selection of illiquid papers for next week's debt purchase operations, bucking market expectations for inclusion of liquid benchmark securities.

RBI's Debt Purchase Strategy Disappoints Markets

The central bank continued its pattern of selecting illiquid papers for bond purchases, avoiding the former benchmark bonds and other liquid securities that traders had hoped would be included in market operations. This approach has kept market sentiment tepid despite the RBI's aggressive bond-buying program.

The Reserve Bank of India purchased ₹500 billion of bonds earlier this week and is scheduled to bid for twice that amount through January 22. However, the focus on illiquid papers has failed to address broader market liquidity concerns.

Supply Concerns Persist Despite Record Purchases

Despite the RBI's record ₹4.70 trillion bond purchases this financial year, concerns about hefty supply continue to weigh on market sentiment. State and central governments are set to raise more than ₹8 trillion through March end, creating ongoing supply-demand imbalances.

"Going ahead, we expect the excess supply concerns to continue unless we witness the revival in demand by pensions, insurance and banks," said Upasna Bhardwaj, chief economist at Kotak Mahindra Bank. State-run banks' preference for state bonds over central government securities has also contributed to elevated yields.

Bloomberg Index Inclusion Awaited

Traders are closely monitoring developments regarding the potential inclusion of Indian bonds in the Bloomberg Global Aggregate Index. Goldman Sachs analysts estimate the index weight could be 0.70% with potential inflows of $10-20 billion post-inclusion, which could provide significant demand support.

Swap Rates Show Easing Pressure

India's overnight index swap rates eased Wednesday, led by receiving pressure in longer-duration swaps. The curve flattened as longer-term rates declined more significantly than shorter tenors.

Indian government bonds rebounded on Tuesday, snapping a two-session losing streak, as the market successfully absorbed hefty state debt supply without major yield spikes. The benchmark 10-year yield settled at 6.61%, down from the previous close of 6.63%, boosting overall market sentiment.

Successful State Debt Auction Calms Market Concerns

Indian states successfully raised ₹30,100 crore ($3.34 billion) through bond sales, marking a positive start to the ambitious ₹5 lakh crore borrowing program for the January-March quarter. While the notes were sold at yields slightly higher than previous auction cutoffs, investors found relief in the fact that the auction was fully subscribed despite concerns about faltering demand.

Traders had expressed concerns about the auction's success following last week's sharp price decline after states announced the record borrowing plan. The 10-year bond yield had risen 5 basis points in two sessions following the announcement.

Strong Institutional Support Drives Recovery

State-run banks emerged as key buyers during the recent volatility, purchasing a net ₹12,500 crore over three sessions. These lenders have been actively acquiring bonds as the Reserve Bank of India continues its supportive open market operations.

The RBI bought bonds worth ₹50,000 crore on Monday and is set to purchase another ₹1 lakh crore of bonds in January. The central bank will also conduct a foreign exchange swap worth $10 billion next Tuesday, providing additional liquidity support.

Corporate Debt Market Maintains Strong Momentum

The corporate bond segment continues to witness robust activity, with Adani Enterprises recently demonstrating strong market appetite by fully subscribing its ₹1,000 crore NCD issue within 45 minutes. Multiple companies have received board approvals for significant debt fundraising programs across sectors.

Market Focus Shifts to Budget Announcement

With state debt supply concerns easing following the successful auction, market attention is likely to pivot to the central government's budget announcement in February. "Traders are now cautiously waiting for the budget as the gross borrowing number beat expectations due to maturities this year," said Alok Sharma, head of treasury at ICBC, Mumbai.

India's longer-duration overnight index swap rates fell, reversing course after three sessions. The one-year OIS inched lower to 5.48%, while the two-year OIS rate fell 1 basis point to 5.58%. The five-year OIS rate declined 2.25 basis points to 5.95%.

Rating Upgrade Supports Market Confidence

Market sentiment continues to benefit from S&P Global Ratings' upgrade of India's long-term sovereign credit rating to BBB. Investors are also monitoring the upcoming announcement regarding Indian bonds' inclusion in the Bloomberg Global Aggregate Index, expected next week, though market participants believe this development is largely priced in.