MUMBAI, Sept 24: Investor appetite for Indian government bonds has improved markedly in recent weeks on fading fears of a hurried interest rate hike by the central bank.

But with inflation hovering near recent multiyear highs, traders are too cautious to spur a broad rally and, instead, are looking for stopgap bargains such as buying illiquid paper for relatively high yields.

From June through August, Indian government bond prices fell to their lowest in two years as a soaring inflation rate fanned fears of an immediate interest rate hike by the Reserve Bank of India. India's year-on-year inflation hit a 3 1/2-year high 8.33pc in late August, before easing mildly to 7.87pc in the week ended Sept 11.

However, recent central bank comments that demand wasn't driving inflation suggested the RBI probably isn't planning an interest rate hike - a step that deters demand - to temper prices.

This helped bonds bounce off lows but with the inflation outlook still uncertain, the market doesn't yet want to look beyond the short-term. And, in the absence of clear medium-term direction, buying illiquid bonds probably is a handy short-term trading strategy.

"There's definitely money to be made on illiquid papers, but it has to be done with caution: if the market turns negative again, these bonds could turn more vulnerable," says Rajat Kumar, head of trading at Standard Chartered Bank in Mumbai.

Amit Bansal, head of treasury at Barclays Bank in Mumbai, observes that the yields on many illiquid bonds rose much more sharply in recent months compared with liquid paper, raising the prospect of price gains on them when they eventually realign with the rest of the yield curve. The 11.83pc, 10-year bond currently yields 6.58pc, sharply above the 6.03pc yield on the more actively traded 7.37pc paper of the same tenor.

Such wide spreads between bonds of similar tenors are usually aberrations left behind by big market swings - they get realigned over a short period of time after the market regains some stability.

Indeed, it's this lagged adjustment that a buyer of illiquid paper aims to profit from. Traders expect the yield on the 11.83pc paper to eventually decline to align better with the rest of the yield curve.

Similarly, the yield spread between the 8.35pc bond, due 2022, and the more actively traded 8.07pc paper, due 2017, has widened to 49 basis points from 26 basis points on August 1. Many traders expect the yield on the 2022 paper has some room left to decline.

"There is no single rule to go by when picking an illiquid paper to buy - it could be of any maturity or coupon. It's your own judgment whether that paper has scope for gains," Standard Chartered's Kumar said.

A recent increase in demand for less-traded paper has caused the yield spreads between them and their liquid counterparts to compress, but probably there's scope for the trend to continue.

S.P. Prabhu, fixed income analyst at IDBI Capital Market Services in Mumbai, says that buying in illiquid securities should continue as a short-term trading tactic in the coming weeks, albeit in modest volumes, until fresh factors set a clear direction for the market. - Dow Jones Newswires