Oct. 20 (Bloomberg) -- Bonds that protect against faster inflation may be the biggest bargain in the Treasury market even as gains in consumer prices slow.

Treasury Inflation-Protected Securities fell 8 percent since June as investors shunned all but the most easily traded debt amid the seizure in credit markets. TIPS were the only part of the U.S. government bond market to lose money in that time as Treasuries of all maturities gained 2.12 percent, according to Merrill Lynch & Co. indexes.

BlackRock Inc., Brown Brothers Harriman & Co., DWS Investment GmbH and New Century Advisors are buying the securities because inflation will likely increase at a faster pace over the next decade than the 1 percent annual rate TIPS yields suggest. Consumer prices, unchanged in September, may increase 4.5 percent this year and 2.65 percent in 2009, according to the median estimate of 69 forecasters surveyed by Bloomberg.

``There is something broken here,'' said William Chepolis, who oversees more than $9 billion of bonds as a fixed-income fund manager in New York at DWS Investment, a unit of Frankfurt- based Deutsche Bank AG. ``At some point the market will figure out that it has overcorrected and will come back.''

The slump in 10-year TIPS pushed yields on the securities to within 0.87 percentage point of benchmark notes on Oct. 10. The so-called breakeven rate, a measure of what investors expect the rate of inflation to be over the life of the securities, fell to the lowest level since January 1999.

`Dire Economic Scenarios'

Since then, the rate has risen 26 basis points, or 0.26 percentage point, suggesting that TIPS are starting to outperform bonds that aren't linked to inflation. TIPS, which pay interest on a principal amount that rises with the Labor Department's consumer price index, make up about $520 billion of the $4.8 trillion in U.S. marketable debt outstanding.

The last time the breakeven rate was as narrow was 1999, when it shrank to 0.80 percentage point before widening more than 1.30 percentage points to 2.11 percentage points six months later amid concern that inflation would accelerate. TIPS gained 1.8 percent during that period, compared with a loss of 3.8 percent for Treasuries, Merrill Lynch index data shows.

A Barclays Capital Inc. bond pricing model suggests 10-year breakeven rates should be 1.30 percentage points higher, based on the outlook for inflation, according to an Oct. 9 note to clients.

`Dire' Outlook

The difference in yields reflects ``the most dire economic scenarios,'' according to Michael Pond, a New York-based interest-rate strategist at Barclays who was rated the leading TIPS analyst by Institutional Investor magazine.

The inflation rate will fall below 1 percent by the second half of next year as the economy lapses into a recession, said David Rosenberg, chief North American economist at Merrill Lynch in New York. If true, that would make TIPS less attractive.

``When we are completely through this de-leveraging phase and we start to see aggregate demand outpace aggregate supply we will start another inflation phase,'' said Rosenberg. ``Whether that is 2011 or 2012, take your pick.''

Inflation expectations, as measured by 10-year TIPS, climbed in March to the highest level since August 2006 as commodity prices surged.

The breakeven rate touched 2.68 percentage points March 13, less than a week before JPMorgan Chase & Co. agreed to buy Bear Stearns Cos. in the first failure of a major U.S. financial institution during the credit crisis that has cost $660 billion in losses and writedowns, according to data compiled by Bloomberg.

Commodities Tumble

Crude oil prices has tumbled more than 49 percent after reaching an all-time high of $147.27 a barrel July 11, while the Reuters/Jefferies CRB Index of 19 raw materials has slumped more than 40 percent after touching a record high on July 3.

``The TIPS market reflects the risk that we will have a dis-inflationary environment,'' said Brian Weinstein, who manages $9 billion in inflation bonds at New York-based BlackRock. ``Even if you believe there is a disinflation risk you still might get paid to buy TIPS as an insurance policy because they are so cheap.''

Fed officials watch the TIPS market for signs of inflation expectations and referred to the securities in 12 of 13 policy- setting meetings since 2007, according to minutes of the gatherings. Policy makers led by Ben S. Bernanke mentioned five- year TIPS at their April 30 meeting, where they lowered their target interest rate for overnight loans between banks to 2 percent from 2.25 percent.

Bigger Part

TIPS may become a larger part of the government's plan to pay for the Treasury's $700 billion financial rescue program and a widening budget deficit, which will increase outstanding debt by $1.35 trillion next year, bond strategists at New York-based JPMorgan Chase & Co. said in a Sept. 26 report to clients.

Bond dealers trimmed their holdings of TIPS as the credit crisis accelerated and lending dried up, causing investors to demand the most easily traded government debt. While TIPS account for almost 11 percent of the Treasury market, they make up less than 2 percent of the average daily trading volume among the 17 primary dealers of U.S. government securities, according to Federal Reserve data.

The supply of TIPS by the primary dealers that trade directly with the Federal Reserve fell by $986 million to $3.54 billion in the week ended Oct. 1, the lowest since July. Daily transaction volume fell 18 percent, according to Fed data.

``Breakeven rates reflect the extreme sensitivity to liquidity in the market,'' said Nils Overdahl, a bond-fund manager at New Century in Bethesda, Maryland, which oversees $500 million. ``All markets right now are broken and to the extent that sentiment improves you will see everything gravitate back toward a more fundamental valuation.''

Bid-Ask

Trading in other parts of the Treasury market also suffered. The gap between the asking and selling prices for older, or off-the-run, debt widened, suggesting investors are shunning the securities because they are harder to trade than new ones.

The difference in the so-called bid-ask price on 10-year notes widened to 8/32 for securities issued in February, from less than 1/32 for debt issued in August, according to BG Cantor Market Data.

Nine of 75 economists surveyed by Bloomberg News expect the economy to contract in 2009.

``One outcome could be disastrous to inflation and the real economy and the other could be inflationary,'' said Kenneth Volpert, who manages $18 billion of the debt for Vanguard in Valley Forge, Pennsylvania. ``I'd like to see what happens to the real economy, and that may mean you miss some opportunity.''

The government's sale of 10-year TIPS on Oct. 8 showed that buyers may already be returning to the market. Investors bid for 2.22 times the $6 billion available, above the bid-to-cover average of 1.93 times for the past dozen auctions.

``Historically the best time to buy TIPS is in late October or early November,'' said James Evans, a senior vice president at New York-based Brown Brothers Harriman & Co. who helps oversee $15 billion in fixed-income assets. ``A lot of the downside has already been priced in.''

To contact the reporter on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net

Last Updated: October 20, 2008 15:37 EDT