Jan. 12 (Bloomberg) -- At a time when central banks are attempting to prevent deflation, the hottest investments in the government bond market are securities that protect debt holders against rising consumer prices.

Inflation-linked debt from the U.S. to Japan returned 5.77 percent since November, including price gains and reinvested interest, compared with 1.55 percent for the government-bond market, according to indexes compiled by New York-based Merrill Lynch & Co.

Pacific Investment Management Co., Vanguard Group and Fifth Third Asset Management, which oversee a combined $1.8 trillion, are scooping up so-called linkers on speculation efforts by policy makers to reignite the global economy will lead to faster inflation than is currently priced into the securities. Yields on U.S. Treasury Inflation-Protected Securities, or TIPS, indicate almost no rise in consumer prices for the next decade.

“They’re breathtakingly cheap,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third. “This one’s going to take a while to come to fruition but I’m buying them so dirt cheap I’m willing to have a little patience.”

Last year, inflation-linked securities lagged behind the rest of the government bond market through November, losing 5 percent, as the U.S., Europe and Japan entered simultaneous recessions for the first time since World War II and commodities prices as measured by the Standard & Poor’s/Goldman Sachs Commodities Index tumbled 60 percent from their peak July 11. Treasuries returned 14 percent in 2008, the most since 1995, according to Merrill indexes.

Hedge Fund Sales

At the same time, hedge funds that purchased the debt with borrowed money were forced to sell as lenders reined in credit, according to Kenneth Volpert, who oversees $180 billion in taxable bonds for Vanguard in Valley Forge, Pennsylvania. The world’s biggest financial institutions reported more than $1 trillion in losses and writedowns since the start of 2007.

“There’s been a lot of selling related to de-leveraging hedge fund stuff that just caused TIPS to get unbelievably cheap,” Volpert said.

TIPS due in 10 years yield 0.58 percentage point less than Treasuries, compared with an average of 2.11 percentage points since 2000. In November, TIPS yields rose as much as 0.08 percentage point above Treasuries.

The U.S. securities pay interest on a principal amount that rises with the Labor Department’s consumer price index. The difference in yield, or break-even rate, between yields on TIPS and Treasuries of the same maturity represents traders’ expectations for the rate of inflation over the life of the bonds.

Kokusai Shuns TIPS

The benchmark 2.125 percent 10-year inflation-indexed Treasury note ended last week 102 27/32 to yield 1.81 percent, according to BGCantor Market Data. The breakeven rate rose 46 basis points last week.

The rally in inflation-linked debt left them more in line with inflation forecasts, according to Masataka Horii, one of four managers for the $51 billion Kokusai Global Sovereign Open fund in Tokyo, the biggest bond fund in Asia. U.S. consumer prices may rise 0.65 percent this year, according to a Bloomberg survey of economists.

“U.S. domestic demand is declining,” said Horii, whose fund avoids TIPS. “Inflation will stay low for a while.”

The U.S. Labor Department may say Jan. 16 consumer prices fell 0.9 percent in December, after tumbling by a record 1.7 percent in November, according to the median estimate of economists surveyed by Bloomberg. Prices excluding food and energy in Japan rose at a 1 percent rate in November, down from 2.4 percent in August. The European Union’s rate fell to 1.1 percent in December from 3.5 percent in July, according to a Bloomberg survey.

Wal-Mart Cuts

Bentonville, Arkansas-based Wal-Mart Stores Inc., the largest retailer, and Advanced Micro Devices Inc. in Sunnyvale, California, the second-largest producer of personal-computer processors, said they lowered prices as the economy slowed.

Deflation can hinder investment and spending, delaying an economic recovery. Federal Reserve Bank of Richmond President Jeffrey Lacker said Dec. 3 he was open to purchasing government debt to keep borrowing costs low and ward off deflation. Central banks are slashing interest rates and governments are earmarking trillions of dollars to pump up the economy.

The Fed cut its target interest rate for overnight loans between banks to as low as zero last month from 4.25 percent at the start of 2008, while U.S. policy makers flood the world with an extra $8.5 trillion through 23 plans designed to bail out the financial system. The European Central Bank lowered its benchmark rate to 2.5 percent last month from 4.25 percent in October.

Obama’s Plan

President-elect Barack Obama urged Congress on Jan. 8 to pass a stimulus package that may total $775 billion or risk having the U.S. sink deeper into economic crisis. “If nothing is done, this recession could linger for years,” he said in an address at George Mason University in Fairfax, Virginia.

Credit markets show the freeze is starting to thaw. It costs banks on average 1.20 percentage points more than the U.S. government to borrow for three months, down from 4.64 percentage points in October. The so-called TED spread is the narrowest since before Lehman Brothers Holdings Inc. filed for bankruptcy on Sept. 15, though it’s still about three times higher than before markets started to collapse in July 2007.

The amount of U.S. commercial paper outstanding, or corporate debt due in nine months or less, rose $83.1 billion during the week ended Jan. 7 to a seasonally adjusted $1.76 trillion, the most since Sept. 10, the Fed said last week.

Gross Says Buy

Pimco co-Chief Investment Officer Bill Gross, who manages the world’s biggest bond fund, recommended inflation-linked debt last week.

TIPS “can benefit if and when the government’s efforts to reflate begin to take hold,” Gross, head of Newport Beach, California-based Pimco’s $128.4 billion Total Return Fund, wrote in a note to clients on Jan. 8. While break-even rates suggest consumer prices will fall an average of 1 percent a year for 10 years, that’s “possible, but not likely,” Gross said.

Pimco turned bullish on TIPS in October, covering a July bet that the debt would fall. The firm started the wager as crude oil rose to a record $147.27 a barrel, said Mihir Worah, who oversees the $11.1 billion Real Return Fund for the firm. Oil ended at $40.83 in New York trading on Jan. 9.

‘Unreasonable’ Outlook

Barclays Wealth, which manages about $215 billion, estimates TIPS are pricing in 11 percent deflation, according to Kevin Lecocq, the firm’s London-based chief investment officer.

“While we may get small deflation in 2009,” he told Bloomberg Television last week. “But to get an 11 percent drop is unreasonable.”

Demand for TIPS soared at the Treasury’s auction last week of $8 billion of the securities. Investors bid for 2.48 times the amount sold, the most since Jan. 12, 2000, when the so- called bid-to-cover ratio was 3.07, according to Treasury data.

The next TIPS sale, a 20-year auction, is scheduled for Jan. 26.

Inflation-linked debt issued by the U.S., U.K., and Germany had its best month in December, and the second-best in Japan, Merrill Lynch indexes show.

The securities returned 10 percent in the U.K., compared with a 5.4 percent gain for all gilts. German inflation- protected debt rose 5.6 percent, compared with 1.7 percent for all the country’s sovereign debt. U.S. TIPS rose 5.8 percent, and Japanese linkers rallied 3.1 percent, the most since returning 3.2 percent in August 2004, according to the indexes.

In the U.K., the 10-year breakeven rate fell to 1.77 percentage points from 4.15 percentage points in July. The comparable rate in Germany declined to 1.6 percentage points from 2.7 percentage points in July.

“TIPS are a great buy,” Vanguard’s Volpert said. “The economy will start coming back, and risk will be taken again, and inflation expectations will work their way up.”

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net

Last Updated: January 12, 2009 12:35 EST