Healthy demand for India's long-term government bonds has shrunk the yield spread with the benchmark paper to the lowest in a year, flattening the yield curve, traders said.

The recent demand boost is backed by foreign banks' purchases for forward rate agreements (FRA), which are contracts that allow parties to lock in rates for a future date, traders said. Insurers entering such deals can offer guaranteed returns to policy holders, while the counterparty banks charge a fee to hold the bonds.

"With government bond auctions coming to an end, insurance companies have been front-loading their buying of longer-tenure bonds, with a view to fulfill their ALM (asset-liability management) requirements and hedge interest rate risk," Rahul Bhuskute, CIO, Bharti AXA Life Insurance, said.

Insurers, which typically buy long-term bonds, boost debt purchases in the last quarter of the financial year that ends March 31.

India's 10-year benchmark bond yield traded at 7.13% on Wednesday, while the 30-year and 40-year notes yielded around 7.19% each. The 6-basis-point yield spread between the notes is the lowest since February last year.

The yield curve's flattening bias should persist until March-end, Bharti AXA's Bhuskute said.

A fall in overnight index swap rates, another contract used to bet on the direction of interest rates, and fresh investment limits for foreign banks have pushed up interest in FRAs, traders said.

A December-end central bank draft circular, which said market-makers may take long positions in bond forwards without any limits, could also have boosted activity.

"Any drop in swap rates is deemed favorable for an insurance company as banks use swaps to fund bond FRAs. Insurance companies can thus leverage on higher yields due to higher bond-OIS spread," Niraj Kumar, chief investment officer at Future Generali India Life Insurance Company, said.

FRAs are the "most lucrative option for hedging interest rate risks at this juncture", Kumar added.

Outstanding FRAs are said to have topped 2 trillion rupees (about $24 billion) currently, multiple traders said. No official data for FRA trades is available.

Foreign banks have net bought bonds worth 685 billion rupees this year, of which a major part could be for FRAs, traders said.

($1 = 83.0875 Indian rupees) (Reporting by Dharamraj Dhutia; Editing by Mrigank Dhaniwala)