MUMBAI - Indian government bond yields ended lower on Wednesday, with the benchmark bond yield dropping to its lowest level in two months, as mutual funds stepped up bond purchases ahead of a taxation change from next week.

The 10-year benchmark 7.26% 2032 bond yield ended at 7.2897%, the lowest level since Feb. 3, after closing at 7.3240% on Tuesday.

"There have been good flows into long debt funds, after the indexation announcement, and this may be flowing into government bonds," said VRC Reddy, treasury head of Karur Vysya Bank.

Indian mutual funds are seeing a spurt in inflows into debt-oriented schemes as, effective April 1, India will begin taxing investments in debt mutual funds as short-term capital gains.

Funds have been witnessing outflows into liquid schemes, leading to weak participation at the 91-day Treasury bill sale on Wednesday and forcing the Reserve Bank of India (RBI) to cancel the auction, traders added.

This was the first time since February 2016 that the central bank has not accepted any bids for 91-day T-bills.

"The next key triggers for the market are the government borrowing calendar and the RBI policy, which will provide more clarity. Till then we will see yields moving in a narrow range," said Yogesh Kalinge, vice president at AK Capital Services. India aims to gross borrow a record 15.43 trillion rupees ($187.54 billion) via bonds in the next financial year. Market participants expect the borrowing to be between 55% and 58% of this target.

The borrowing calendar is likely to be announced by Friday evening, with the RBI decision expected on April 6. A Reuters poll forecast that the RBI will raise rates by 25 basis points (bps) and then pause for the rest of the year.

"While most market participants are expecting a 25-bps hike in April, talks of status quo are also gathering pace," Kalinge added. ($1 = 82.2750 Indian rupees)

(Reporting by Bhakti Tambe and Dharamraj Dhutia; Editing by Janane Venkatraman)