TOKYO, Jan 18 (Reuters) - Rising consumer prices in Japan have the spotlight on an asset neglected during decades of deflation: inflation-linked bonds.
Designed to offer protection from inflation, the bonds pay extra principal at maturity in proportion to changes in inflation. For years investors shunned them while inflation proved ephemeral. Now they are outperforming regular bonds.
The backdrop is particularly good for inflation insurance because the Bank of Japan has not raised rates to stifle inflation, which has capped yields on the Japanese government bonds (JGBs).
A way to value inflation-linked bonds is through the break- even inflation rate that measures the gap in the yields between the so-called "linkers" and JGBs. The break-even rate for 10-year inflation-linked bonds and 10-year JGBs rose to a 10-year peak of 1.424% in November, up from 0.9115% a year earlier
The break even rate remains elevated at 1.2135% .
Japanese fund manager Asset Management One offers an investment trust that owns inflation-linked bonds which earned a 4.2% return for the year to December versus zero return for its trust holding JGBs.
"Historically investors of inflation-linked bonds have not had success because expectations for Japan's inflation didn't last long," said Yusuke Nakamura, who manages the inflation-linked bond fund for Asset Management One.
"But this time the environment for the inflation-linked bonds is different."
After spending most of the last two decades below 1% and years below zero, Japanese inflation has run above the BOJ's 2% target for almost two years.
The BOJ has dialled back its support for the JGB market by relaxing targets on 10-year yields, but it has not moved directly to address inflation.
"Even as the prices rose in Japan, the BOJ left its ultra-low rate policy unchanged, which is a positive factor for the inflation-linked bonds," said Katsutoshi Inadome, a senior strategist at Sumitomo Mitsui Trust Asset Management.
To be sure, the market for inflation-linked bonds is smaller than that for JGBs so they sell at a negative yield because of that reduced liquidity and can be vulnerable in a falling broader market.
After launching in Japan in 2004, the Ministry of Finance halted issuance in 2008, when inflation turned sharply negative, and it did not return to the market until 2013.
Inflation-linked bonds on issue were 11 trillion yen ($75.58 billion), accounting for 1% of Japan's 1,096 trillion yen government bond market in March 2022, the most recent data available from the finance ministry.
($1=145.54 yen) (Reporting by Junko Fujita; Editing by Tom Westbrook and Christian Schmollinger)
