Faith in ECB’s eventual success revives euro inflation-linked bonds

Strong demand for a new Spanish inflation-linked bond this week suggests investors are betting that the European Central Bank will avert deflation and eventually succeed in reigniting consumer price increases in the euro zone.

Spain raised 5 billion euros in its second sale this year of bonds providing protection against price increases, known as linkers. Bids totalled almost 12 billion, even as inflation in the currency bloc has dropped to a new low of 0.3 percent, far under the ECB’s target of close to two percent.

It has joined a small euro zone club of Italy, France and Germany in issuing such bonds, offering investors an opportunity to diversify their portfolios.

To fend off deflation and revive growth, the ECB unveiled plans last week to buy covered bonds and asset-backed securities, a move President Mario Draghi hopes will inject up to an extra 1 trillion euros ($1.3 trillion) into the flagging euro zone economy.

Record low inflation expectations, as expressed by the ECB’s preferred five-year, five-year forward breakeven rate, are piling pressure on the ECB to expand its asset purchases to include government bonds, a tool known as quantitative easing.

This gauges expectations now of where five years from now, in 2019, the market will expect inflation to be five years further into the future, ie in 2024.

But even without QE, some investors believe the ECB’s measures will eventually work and are buying the inflation-proofed bonds with a longer-term view to profit.

“Selectively we’ve bought some inflation-linked bonds recently in longer maturities, over 10 years,» said Michiel de Bruin, co-head of Global Bond Fund at F&C Netherlands, which manages $30 billion of assets in rates and money markets.

“Although there’s a lot of uncertainty about developments of European inflation … the ECB has been reacting to it. It has committed to expanding the balance sheet. Inflation will move away from the really low levels we’ve seen.”

Some market participants say a modest recovery in inflation is inevitable as the euro’s near 8 percent fall against the dollar this year will help to lift price pressures in the end via higher costs for imports.

The ECB’s latest staff projections take account of a potential weakening in the euro against the dollar, which could alone lift inflation by 0.2-0.3 percentage points in 2015 and 2016. The bank expects inflation to average 0.6 percent in 2014, before ticking up to 1.1 percent in 2015 and 1.4 percent in 2016 though lower oil prices could scupper those rises.

Bouncing back

Investors who kept faith with the linker market have been rewarded. The bonds have reversed last year’s losing streak despite the threat of deflation, even though their performance still lags that of conventional debt in the currency area.

They have managed total returns of nearly 5 percent year-to-date, according to indexes compiled by Barclays Capital.

Italian linkers, in particular, have outperformed higher-rated French and German peers, returning 13 percent, not far from the hefty 18 percent returns on conventional Italian debt.

Some investors say the ultra-low levels of breakeven rates – – a proxy for inflation expectations which are the difference between the yield on nominal bonds and the «real» yields on linkers – represent a cheap buying opportunity.

“We do think ultimately the ECB does have credibility and if you look at 10-year 10-year breakevens in France are as low as 1.20-1.30 which to us seems too low,» said Owen Murfin, portfolio manager (global bonds) at Blackrock, one of the world’s biggest bond investment houses.

“Therefore we quite like seven-year inflation-linked bonds. I think inflation-linked bonds are quite desirable in Europe at the moment more for a longer term view.”

Borrowing costs for the peripheral euro zone countries, many of which suffered badly during the bloc’s debt crisis, have fallen over the past two years following Draghi’s promise to do whatever it takes to save the euro. This has made investors more comfortable with riskier assets from the likes of Italy and Spain.

There are some, however, who say conventional bonds have become too expensive and that their yields may rebound as the likelihood of a U.S. interest rate rise by the Federal Reserve draws closer. In that case, inflation-linked bonds could provide a cushion from sharp price swings in conventional or «nominal» debt, as their value erodes less.

“It’s a good product when you think that the absolute yield level on the nominal is really low and you fear that yields could go up … Then it can be interesting to switch from nominal from (inflation-linked),» said Emmanuel Smiecench, Managing Director, European Bond Syndicate at SGCIB.

“Breakevens are pretty low, and you could think they could tighten further, but it is not a bad level to have some exposure.”


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