Inflation-linked government bonds have had a good 2009, comfortably outperforming their fixed-rate equivalents. The steady uptrend in prices this year follows a turbulent 2008, during which a deflation scare pushed inflation-linked bond prices down immediately after the Lehman collapse.

The chart below shows the NAV performance over the year to date of the four Dublin-based inflation-linked ETFs in the iShares range, with prices rebased to 100 at 31 December 2008.

Meanwhile, investors have shown consistent interest in this sector, with assets more than doubling from a year ago – one of the fastest growth rates in the European ETF market.

Can this demand be expected to continue? And what is the investment outlook for this specialist asset class?

US Breakeven Inflation Rate

The chart above, taken from a recent iShares publication, shows the breakeven inflation rate between five, ten and twenty year fixed-rate and inflation-linked government bonds (the rate at which fixed-rate and inflation-linked bonds would give an investor the same return). Other things being equal, you’d prefer inflation-linked to fixed-rate bonds if you expect average inflation over the relevant period to be above the breakeven rate. If you expect actual inflation to turn out lower than the breakeven rate, you’d prefer fixed-rate bonds.

Until last summer this key measure had traded within a narrow range for some time and there was little difference in the breakeven rates for different bond maturities.

But as the credit crisis intensified, a sharp rally in fixed-rate government debt and a sell-off in inflation-linked bonds late last year pushed US breakeven rates much lower, to the extent that a period of outright deflation was discounted over five years, while the ten year breakeven rate hit zero and the twenty year rate fell below 1%.

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