Euro deflation threat crushes investors' inflation-protected bet

By Jamie McGeever and Emelia Sithole-Matarise

LONDON (Reuters) - Tumbling inflation and a buyers' strike among hedge funds and other speculative investors is making this a loss-making year for holders of euro zone inflation-linked bonds.

But they should be back in profit next year as the currency bloc evades outright deflation and as institutions seek to diversify while protecting themselves against the longer-term risks of rising prices.

Inflation-linked bonds, known as "linkers", guarantee a return higher than the rate of inflation if held to maturity. They are popular with investors seeking safe returns with little to no risk, especially when inflation is rising.

But inflation in the euro zone fell to 0.7 percent in October, the lowest in four years and enough to make the European Central Bank cut its benchmark rate to 0.25 percent.

November's inflation ticked up to 0.9 percent, but that still undershoots the European Central Bank's target of "below, but close to 2 percent". It's also lower than U.S. inflation of 1 percent and even Japan's equivalent of 1.1 percent.

"We would need a Japan-like scenario to make linkers unattractive from here," said Kari Hallgrimsson, EMEA head of inflation trading at JP Morgan in London, referring to Japan's 20-year battle against falling prices.

"As an investor, you'll be worried about if and when inflation picks up. It can be difficult to contain given the amount of stimulus out there," he said.

STEEP PREMIA

JP Morgan's own euro zone inflation-linked index is down 0.62 percent on a total returns basis so far this year. It rose 16.37 percent last year.

The UK, where inflation of over 2 percent is above the Bank of England's target, is on track to return investors just under 2 percent this year.

Treasury Inflation-Protected Securities in the United States, known as TIPS, are on track to post the biggest loss of around 8 percent, according to JP Morgan and Markit iBoxx data. Investors have driven U.S. market-based interest rates higher in expectation the Federal Reserve will soon reduce its $85 billion a month monetary stimulus.

The euro zone's poor performance has been driven by France and Germany, but prices may now have fallen far enough to tempt buyers back, with some in the market expecting the ECB to take further monetary policy measures to fight disinflation.

For example, the 10-year "break-even" rate in Germany - the difference between nominal yields on fixed-rate bonds and real yields on comparable inflation-linked bonds - is 1.24 percent.

"That is very low. And for us, it will be a floor," said Franck Dixmier, chief investment officer of fixed income at Allianz Global Investors in Paris.

"This market is cheap because there is no real interest from fund investors and breakevens are very low. This is an opportunity," he said.

Dixmier has around 125 billion euros ($170 billion) of assets under management in his fixed income portfolio, of which around 4 percent, or 5 billion euros, is in linkers.

He is overweight Italian linkers and funds that position with an underweight position in France and Germany.

As data from JP Morgan and closely-tracked Markit iBoxx returns show, Italian linkers have performed relatively well this year. That's because investors perceive Italy as a higher credit and inflation risk relative to its two larger euro zone counterparts and so demand a higher premium.

The Italian linkers also offer about 40 basis points yield over comparable fixed-rate bonds, Dixmier at Allianz said.

Inflation-linked bonds typically account for around 5-10 percent of an average portfolio. That should remain the case next year, but if inflation remains weak, their appeal could diminish even further.

By some measures, however, linkers are expensive. Franck Triolaire, executive director and head of European inflation trading at Morgan Stanley, points to what he says is the "unjustified" premium in the forward market on 5-year linkers in five years time over cash break-even rates of around 1 percentage point.

"Linkers are too expensive relative to actual inflation prints, and we need confirmation that inflation has bottomed before that will change," he said.

Until that becomes apparent, investors will steer clear of these bonds and look instead to higher-yielding assets such as peripheral sovereign bonds, he said.

(Graphics by Vincent Flasseur; Editing by Ruth Pitchford)