Oct. 20 (Bloomberg) -- India's government bonds rallied after the central bank unexpectedly cut its benchmark interest rate for the first time since 2004.

The Reserve Bank of India reduced its overnight lending rate, or the repurchase rate, by 1 percentage point to 8 percent, saying the global financial uncertainty is ``transmitting'' to India. Bonds extended gains after the government canceled a debt auction scheduled for today.

``The central bank has responded pro-actively to the needs of the situation and will bring investor confidence back,'' said Krish Ramkumar, who manages the equivalent of $1 billion in Indian debt at Sundaram BNP Paribas Asset Management Co. in Mumbai. `` We are now going to see a significant downward shift in interest rates.''

The yield on the most frequently traded 7.94 percent note due May 2021 slid 30 basis points to 7.7 percent at the 5:30 p.m. close in Mumbai, according to the central bank's trading system. The price of the bond rose 2.35 rupees per 100-rupee face amount, to 101.90.

The benchmark 8.24 percent note due April 2018 wasn't traded today because of the so-called shut period before an interest payment tomorrow.

The central bank last week slashed the proportion of deposits lenders must keep as reserves by 2.5 percentage points to 6.5 percent starting Oct. 11, adding 1 trillion rupees ($20.5 billion) to banks.

Inflation that accelerated to a 16-year high and a global credit crunch, which caused writedowns of about $600 billion due to the collapse of the U.S. subprime mortgage market, pushed India's benchmark 10-year yield to 9.48 percent in July, the highest since 2001.

Debt Sale Cancelled

The rate advantage between India and the U.S. narrowed to 6.5 percentage points from 7.5 percentage points following today's decision. The gap in comparison to Malaysia narrowed to 4.5 percent from 5.5 percent and to 4.25 percent from 5.25 percent for Thailand.

Bonds gained for a fourth day after the government canceled the plan to sell 100 billion rupees ($2.04 billion) of notes as part of its annual borrowing plan.

The government was scheduled to sell 60 billion rupees of new six-year notes and 40 billion rupees of the 7.95 percent debt due 2032.

``Investors would have had to book losses because the rate cut shifted the yield curve downward,'' according to Kamlesh Chand, a fixed-income trader at IndusInd Bank Ltd. in Mumbai. ``The cancellation enabled them to adjust their portfolio.''

Policy makers have been taking steps in the past two weeks to ensure local banks had sufficient cash as the worldwide credit crunch pushed up overnight lending rates to a 19-month high on Oct. 10.

The cost of five-year interest-rate swaps, or derivative contracts used to guard against rate fluctuations, dropped to the lowest since Feb. 15. The rate, a fixed payment made to receive floating rates, slipped to 6.785 percent from 6.88 percent on Oct. 17.

To contact the reporter on this story: Anoop Agrawal in Mumbai at aagrawal8@bloomberg.net.

Last Updated: October 20, 2008 09:01 EDT