The tapering by the U.S. central bank comes on the back of a surprise rate hike by the Reserve Bank of India (RBI) on Tuesday.
The selloff in emerging market assets is reviving fears of a similar rout last summer when the rupee slumped to record lows forcing the central bank to sharply raise short-term interest rates.
Foreign funds have been net sellers in Indian debt in five of the last six sessions through Wednesday to the tune of nearly $1 billion, though they still remain net buyers for the month.
In a bid to attract more stable debt flows, the RBI has raised the sub-limit for foreign investment in government bonds to $10 billion from $5 billion with immediate effect for long-term investors like sovereign wealth funds and multilateral agencies.
"Bonds are broadly tracking the rupee. Dealers are a bit cautious in taking long positions because of the uncertainty of how the emerging markets react to the Fed move," said Harish Agarwal, dealer at First Rand Bank in Mumbai.
The benchmark 10-year bond yield closed at 8.82 percent, 5 basis points higher on the day. It rose to 8.85 percent in the session, its highest level since January 3.
Dealers are now bracing for new supply on Friday after a two-week gap when the central bank will sell 140 billion rupee of debt.
Interest rate swaps continued to rise in line with bond yields. The one-year rate rose to its highest in two-and-half months before ending at 8.69 percent, up 11 bps. The benchmark five-year swap rate closed 12 bps higher at 8.45 percent.
