The underperformance of inflation linked bonds may be over

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For Jonathan Baltora, inflation linked bonds fund manager at AXA IM, investors should look through “inflation optical illusions”.

Inflation linked bonds have naturally been underperforming their nominal counterparts in this environment for the last few years. We believe that this trend may well be over as inflation breakevens currently trade well below the central banks’ target and the recent oil price correction is fully priced-in.

Investors should look through the “inflation optical illusions”. While year-over-year headline inflation will likely remain below 0% for some time, we believe monthly inflation, feeding inflation linked bonds coupons, is expected to rebound strongly in the coming months.

Investors would therefore be well compensated for buying cheap medium term inflation protection explaining why demand for the asset class has picked-up.

Inflation linked bonds have outperformed nominal bonds in February as investors are taking advantage of historically low valuations and central banks are rushing to cut rates and ease monetary conditions to prevent their currency from appreciating. Inflation linked bonds are often an attractive value proposition in a currency war situation.

We believe euro inflation linked bonds offer value as the euro area stands to be a winner of the currency war in the year to come. Currency war spillovers have been significant in the inflation linked bond market with Japanese inflation linked bonds outperforming nominal Japanese government bonds by 9.2% as the Japanese yen has dropped by more than 50% over the same period against the US dollar.

The US dollar has strengthened by 20% since December 2011, however the US TIPS market has underperformed nominal treasuries by more than 4%.

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