Indian mutual funds are flocking back to government bonds as inflation is expected to have peaked, leaving limited room for further rate hikes that, in turn, is leading to sharp decline in yields, fund managers said Thursday.

"Market is expecting inflation to have peaked and slow into 2023, while growth headwinds have picked up into 2023, especially in the western world," said Vikram Chopra, a fund manager with DSP Investment Managers.

"This is bringing in fresh investors."

Mutual funds have bought bonds net of more than 150 billion Indian rupees ($1.84 billion) over the last 15 trading sessions, data from Clearing Corp of India showed.

This trend could persist as mutual funds had limited exposure to government bonds over the last few months after the Reserve Bank of India (RBI) aggressively raised interest rates to tackle steep inflation. The central bank has raised rates by an aggregate 190 basis points since May.

Mutual funds shied away from government bonds for most part of October, after suffering heavy losses in September, amid an abrupt reversal in direction of yields when hopes of India's inclusion in a global bond index were dashed.

MFs sold bonds worth net of 184 billion rupees in September when yields rose, with the 10-year benchmark bond yield rising over 20 basis points.

TIDE SEEN CHANGING

Bond yields have declined in the last few trading sessions, with the benchmark yield easing to 7.25% on Thursday, as inflation in India as well as the United States eased in October, raising bets of a policy pivot.

After having opted for larger-sized 50 bps rate hikes in the last three meetings, market participants expect the RBI to opt for a smaller 25-35 bps rate increase next month.

Even though government bond yields have eased recently, they remain a preferred bet with concentration on shorter duration papers, fund managers said.

"On a relative valuation basis, government securities are still more attractive than AAA-rated (corporate) bonds in most part of curve and hence they might be the instrument of choice," Pranay Sinha, senior fund manager, fixed income investments at Nippon India Mutual Fund said.

"Since the funds are on the lower end of duration range and the relative value in government securities there is a decent probability, we can see demand persist."

The three-year government bond was yielding 7.04%, while the five-year notes offered 7.11% yield, and the seven-year papers 7.27%.

"Short-end yields (5-year bond) have moved up sharply this calendar year, which is drawing in fresh investors who are looking for carry (better yield)," DSP's Chopra said.

"With curve flattening significantly, the risk reward remains skewed to investments in the 2026-2029 segments." ($1 = 81.5650 Indian rupees) (Editing by Swati Bhat and Dhanya Ann Thoppil)