The bond party might just be heating up, according to a recent survey of fund managers, thanks in large part to pessimism about global growth, concerns about future corporate earnings and this month's pause in interest rate hikes.

Fund managers are reassessing their long-standing negative view on bonds, according to Merrill Lynch's survey of fund managers for August, which was released Tuesday. Only 22% of fund managers perceive global bond markets to be overvalued, down from 35% in July.

Moreover, asset allocators have begun to reduce their underweight stance on bonds for the first time in three years, the survey said. Roughly 46% of the panel said they are underweight bonds, compared with 65% in June.

"This is consistent with the shift in the broader economic outlook from one of steady or even above-trend growth to one where even the

Federal Reserve

and FOMC is expecting growth to taper," says Ian Lyngen, a Treasury strategist with RBS Greenwich Capital.

While Lyngen emphasizes that few economists predict a recession, he adds that slower growth means equities should underperform relative to where they would without a slowdown. In this scenario, allocation into fixed-income markets makes sense, he says.

"The big call this autumn is shaping up to be: Will this liquidity be directed back into equities or could it head for the bond market instead?" David Bowers, joint managing director of Absolute Strategy Research, wrote in the Merrill Lynch release. ASR analyzed the survey results.

"How investors respond to this question may boil down to whether they expect the Fed to be more concerned about the risk of inflation or the risk of slower growth," Bowers wrote.

Sights on a Slowdown

Bearish sentiment remains high, with 54% of managers surveyed saying that equity-market volatility should rise from current levels and 43% forecasting that world stock markets will be lower in six months' time. About 70% of participants expect the global economy to weaken in the next 12 months, although most do not expect a recession.

This more negative view extends to the world of corporate earnings, with 52% of fund managers expecting profits to deteriorate over the next 12 months, up from 44% in July. Only 29% of participants believe earnings per share growth will hit 10% or more over the coming year, down from 30% in July and 39% in June.

Merrill Lynch's chief North American economist, David Rosenberg, said in the report that economic concerns will increasingly outweigh inflationary worries. He expects the Fed to keep rates on hold until early next year, when he anticipates a rate cut.

The survey adds that a rush to bond funds depends on how Federal Reserve Chairman Ben Bernanke treats the relative risks of higher inflation and weaker economic growth.

Asset allocators were asked whether the Fed should be more concerned over higher inflation or lower economic growth; the results were pretty evenly split. Of the managers, 33% said they were more concerned with economic growth than inflation, compared to 27% who said inflation should be the top worry. The remainder said the Fed should be equally concerned about both.

Safety Belts Remain Fastened

Investors also continue to exhibit a high level of risk aversion, the survey says, with 33% of asset allocators overweight cash. Merrill says this level is an all-time high.

Lipper analyst Jeff Tjornehoj warns that playing it overly safe may not be the best strategy, even though equity markets are volatile.

He notes that people tend to hold more cash when rates hit or surpass 5%, but that cash is not the only place to get a similar return. Tjornehoj found that over the past seven years, funds that invested overseas tended to meet the 5% return mark over any 12-month period, and that international small- and mid-cap funds had the best chance.

More interestingly, he found that the funds that posted a 10% return or greater over the time frame were nearly all equity funds, "and the worst categories for making that return were the 'safe' ones, such as large-cap core or balanced funds or even utilities."

"The chance of getting a 10% earner in those types was only one in four or worse. Only one in 14 large-cap core funds made it," Tjornehoj says. "If the past seven years have left us with anything worth remembering, it's that playing it safe keeps us on the sidelines when the big plays eventually turn up."