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Inflation-linked bonds looking more attractive.

Byline: ANDREW MILLER

LAST week saw the release of inflation data in both the US and the UK. In the US, inflation - as measured by the Consumer Price Index - again surprised on the upside (the fifth time it has done this out of the last six releases) at -1.43% annualised compared to consensus estimates of -1.5%.

In the UK, inflation as measured by the Retail Prices Index came in as per expectations at -1.6% annualised. In the bond market, this news led to a rally in breakeven rates. Breakeven rates are important because they represent the average inflation rate which must be exceeded over the remaining life of an inflation-linked bond for an investor to make more of a profit than would have been made from buying an equivalent conventional bond. Breakeven rates thus often act as a measure of investors' inflation expectations, although other factors may mean they are not always a perfect gauge of these views.

Despite the recent slight rally in breakeven rates, they have in fact fallen significantly over the past few weeks compared to where they were last month. This move has been sharpest in the US, with "front end" (ie short maturity) breakeven rates down by 40-80 basis points (0.40-0.80%) over the month.

Given the high level of correlation between oil prices and breakevens at the front end of the yield curve, part of this move can be explained by the sharp fall in oil prices from the lofty levels of $150/barrel seen last year. However, a closer look suggests that this was not the only factor at play as forward breakeven rates - which can be used to gauge investors' inflation expectations for the years ahead - have also come down. This development would seem to suggest that there has been a small - but discernible - increase in recessionary and deflationary fears. We believe that such fears can no longer be justified; business cycle signals suggest that the worst of the economic downturn is behind us and that the global economy is on its way to a recovery. The better-than-expected start to the US second-quarter corporate earnings season also provides some proof that a prolonged recessionary scenario is unlikely to materialise.

In addition to the above, it's also worth knowing that inflation-linked bond valuations also continue to look favourable relative to conventional bonds. Front-end index-linked bonds are pricing in extremely low breakeven inflation rates, negative in the case of the US, and we do not believe that such low levels of inflation will in fact come to pass, particularly if commodity prices rally once the recovery takes hold. We have used our economist's inflation forecasts to calculate the inflation these bonds are likely to accrue over their lifetime and have compared this to what the market is pricing in. We find that front-end breakeven rates are considerably underpriced by the market at the current time.

Investors who wish to take advantage of this anomaly can do so by building exposure to front-end US and UK inflation-linked bonds. These can be used by investors intending to hold the bonds until maturity or those looking to exit their positions once breakevens have witnessed a sustained rise. Either strategy is practicable as the high liquidity of inflation-linked bonds means that investors can easily exit these investments when they decide that the time is right to sell.

Andrew Miller is regional office head of Barclays Wealth in NewcastleWe find that front-end breakeven rates are considerably underpriced by the market at the current time

CAPTION(S):

FACTOR There was a sharp fall in oil prices from the lofty levels of $150/barrel seen last year.
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Publication:The Journal (Newcastle, England)
Date:Jul 22, 2009
Words:610
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