(Updates for market close)

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

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 was flat at 5.4650%

and the two-year OIS rate closed at 5.4125%.

The five-year swap rate was barely changed at

5.66%.

($1 = 87.8950 Indian rupees)