BlackRock’s Linker Demand Looks Past Europe’s Subdued Inflation

Italy’s inflation-linked government bonds are outperforming conventional securities by the most in three years as investors disregard subdued increases in consumer prices in their hunt for value in euro-region debt markets.

Italian index-linked bonds returned 8.6 percent this year through yesterday, exceeding the 7.5 percent gain on nominal securities, according to Bank of America Merrill Lynch indexes. Investors at BlackRock Inc., the world’s largest money manager, and Henderson Global Investors say they’re turning to the linkers, judging that the rally in the broader market is running out of steam.

“There is more focus on relative value and specific assets that we like rather than the wholesale idea peripheral markets are going to rally,” Chris Allen, a London-based money manager in BlackRock’s euro fixed-income team, said in a telephone interview on May 1. The company, which has more than $4 trillion in assets under management, shifted its focus to investments including Italian inflation bonds after reducing holdings of 10-year Spanish and Italian securities in the first quarter of the year, he said.

Demand for the securities, whose payments are tied to changes in consumer prices, is a boon for the Italian and Spanish governments as they diversify funding sources to spread repayment risks. Spain raised 5 billion euros ($6.83 billion) in its inaugural sale of the securities this week. While inflation is languishing at less than half the European Central Bank’s goal, a recovery in living costs would boost returns for investors at the expense of the issuing nations.

Tumbling Yields

The 1.1 percentage point gap between returns on Italy’s inflation bonds and conventional securities is the widest for the start of the year since 2011. Italian 10-year yields increased three basis points, or 0.03 percentage point, to 2.94 percent as of 12:45 p.m. London time after falling to a record-low 2.885 percent, down from more than 4 percent at the start of the year. Ten-year linkers yielded 1.64 percent before inflation, down from 2.78 percent in December.

Italy sold about 26 billion euros of linkers this year, 20.6 billion euros of six-year inflation-linked bonds known as BTP Italia.

“We’ve been involved in the inflation-linked market in Italy and also the domestic inflation-linked market, the BTP Italia,” BlackRock’s Allen said.

Today’s Data

A report today confirmed consumer prices in the euro area rose 0.7 percent in April from a year earlier, less than half the ECB’s goal of just below 2 percent. The ECB is preparing multiple measures against too-low inflation that could be used as soon as next month, central bank policy makers said yesterday.

“Shorter-dated inflation-linked bonds in the periphery are beginning to look like a better risk-reward here than longer-dates peripheral debt,” said James McAlevey, head of interest rates at Henderson in London, who helps manage the equivalent of $133 billion. “Inflation as an asset class in Europe is very under-owned, not surprisingly given recent underperformance of inflation.”

ECB stimulus designed to boost inflation may yet give a fillip to conventional securities by holding down borrowing costs, enabling the securities to continue this year’s rally.

Yield Spreads

The extra yield investors demand to hold 10-year Spanish bonds over similar-maturity German notes was at 150 basis points, or 1.50 percentage point, today after declining to 144 basis points on May 8, the narrowest spread since July 2010, based on closing-market rates. The yield difference between 10-year Italian and German securities was at 158 basis points, from a three-year low of 147 basis points reached on May 8.

The yield spreads may narrow to levels not seen for at least three years should the ECB maintain stimulus, according to J.P. Morgan Asset Management.

“If the ECB were to continue to keep monetary policy accommodative then even 125 basis points may be exceeded,” David Tan, global head of rates at J.P. Morgan Asset Management in London, said by phone on May 9. “We still think there is some way to go and the value is in the longer-end.” His firm has $1.6 trillion under management.

Santander Asset Management, which oversees the equivalent of $202 billion, remains overweight on its holdings in Spanish and Italian securities and sees room for spreads to halve, Adam Cordery, global head of European fixed income, said by phone on May 8, referring to holding a bigger percentage of the debt than is contained in the indexes used to measure performance.

Spanish Sale

Spain offered index-linked securities to investors for the first time this week. The Treasury sold bonds due in November 2024 via banks at a real yield of 1.835 percent, the Economy Ministry in Madrid said on May 13. Investors bid for more than 20 billion euros of the securities.

France allotted 1.49 billion euros of inflation-linked debt due between 2018 and 2024 in auctions today. That brings this year’s issuance to 7.6 billion euros, according to data compiled by Bloomberg.

“Long-term inflation-linked bonds are an interesting way to hedge the risk of rising interest rates,” said Axel Botte, a Paris-based fixed-income strategist at Natixis Asset Management, which oversees the equivalent of $403 billion of assets. If there were a bond market selloff, index-linked bonds would probably outperform “despite low underlying inflationary pressures in the euro-area,” he said in a phone interview on May 12.

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