Income and long-term gilt funds will continue to outperform the broad market indices in the long term as trading gains will add to the total returns, according to a Merrill Lynch Mutual Fund Debt survey.

"The existing momentum and positive sentiment in the market for government securities, coupled with expectations of a rate cut in the credit policy, have kept market participants bullish," the survey concluded.

"Expectations of improved liquidity also fuelled the bullishness. We got a very high bullish reading for a one-month view. However, there seems to be a revision/moderation in the long-term views," it added.

Merrill Lynch surveyed 14 fund managers, managing over Rs 44,200 crore (Rs 442 billion) in assets, in early April for their views on the market and their portfolio strategies. Fund managers expect gilt yields to remain stable over a one-year horizon, the survey notes.

In terms of returns over a one-month horizon, fund managers expect long-term gilt funds to outperform the indices more than income funds.

Interestingly, 64 per cent of the fund managers in the survey believed that gilt spreads over the corresponding maturity bonds will narrow in April, indicating that the correction in spreads in March was only temporary.

However, over a 12-month horizon, a very small percentage of fund managers believed that spreads will narrow from these levels.

"The long-term view of most fund managers spells 'stable-to-wide' with 50 per cent expecting spreads to remain stable and 43 per cent expecting them to widen," the Merrill Lynch survey added.

In terms of portfolio strategy, the majority of fund managers of both income and long-term gilt funds said they would increase the portfolio duration to enjoy the upside from the expected fall in interest rates. They also expect to increase their allocation to gilts.

Meanwhile, income fund managers held a bullish view on both yields and credit spreads. "The majority plans to increase the portfolio duration, increase exposure to gilts, and keep allocation to bonds stable," the survey noted.

Fund managers continue to hold a stable-to-strong view on economic growth with one fund manager expecting a weaker economy.

Inflation has risen sharply in the recent past to a two-year high, with all subcomponents of the wholesale price index moving higher. But over a longer period, 71 per cent of the fund managers expect inflation to fall.

Debt fund managers moderated their bullishness on the equity markets. While 57 per cent held a bullish view over a 12-month horizon, 36 per cent held a stable view.

Interestingly, all fund categories reported outflows on account of year-end and tax considerations.

This was also aided by weak market conditions. Liquid and short term plans reported the largest outflows, followed by income funds.

Corpuses have eroded significantly, especially in the short term category that now stands at Rs 5,900 crore (Rs 59 billion) from approximately Rs 15,000 crore (Rs 150 billion) at the peak.

Tight liquidity conditions owing to tax outflows and a surplus balance in the Government of India accounts kept overnight rates firm during the month.

Liquid funds were beneficiaries of this development and posted higher returns. Fund managers increased the average maturity in liquid fund portfolios as well, winding down cash and short maturity assets. However, short-term debt funds continued to see outflows for the fourth consecutive month.

Returns were positive as the short end of the yield curve was insulated from the market weakness and because fund managers had positioned their portfolios to service expected redemptions.