Inflation-linked bonds see possible recovery

After months of poor trading, linked to the banking crisis and sagging commodities prices, breakeven rates on US Treasury inflation-protected securities (Tips) have started to rise from their November lows, suggesting investor interest is returning to inflation-linked products.

The breakeven rate is the spread between a Tips and a standard Treasury bond, reflecting expected inflation over the life of the bond and a risk premium. After reaching 260 basis points on July 4, 2008, 10-year breakeven rates on Tips sank to -2bp on November 20, 2008, reflecting greater risk aversion (which would drive investors to Treasury bonds), slackening demand and lower inflation expectations.

Chris Lupoli, London-based inflation strategist at UBS, said: "Over the course of last year, the market went from expectations of very high inflation to the sentiment that we would be entering a deflationary cycle. In this type of environment you are not going to find much investor appetite for Tips."

Bouncing back from their November lows, breakevens reached 63bp on January 22, 2009.

Brice Benaben, global head of inflation trading at Deutsche Bank, commented: "At their lowest levels, breakevens were pricing in a long-term deflationary period. This would have been a reasonable expectation for the next 12 months, but it was unlikely that we would see deflation sustained over a longer-term period of five years, making the breakevens we were seeing very attractive."

Bank moves to sell floors amid lower inflation expectations compounded the impact of falling commodities prices and investor deleveraging on inflation-linked products. Benaben noted: "This creates a vicious cycle - when breakevens start to decrease, the probability of having a negative coupon is higher. As a consequence, banks have to sell more inflation-linked products to hedge these options and, in doing so, they push the forward inflation rate even lower."

Tips include an embedded option, which provides principal protection against deflation and has attracted investor interest. The product still offers value despite the climb in breakevens, Benaben said: "The decline in oil prices is still impacting the inflation rate. Currently, the consumer price index is reflecting the expectation for negative inflation and that will continue because of the lag effect of oil prices."

In addition, support for the economy via prospective or actual quantitative easing seems to have attracted attention to Tips. Lupoli commented: "Authorities are now specifically aiming to deflect deflation; it makes sense to start thinking about the Tips market and where breakevens will be five years out."

See also: Crossing the floor