US inflation bonds shine on commodity, debt jitter

* TIPS fare well on rising commodity prices, debt worries

* Investors pare deflation outlook, see rising prices

* Ten-year TIPS break-evens run close to core inflation

By Richard Leong

NEW YORK, June 1 (Reuters) - U.S. inflation bonds fared better than regular Treasuries on Monday as commodity prices hit multi-month highs and worries intensified over the long-term fallout from the government's massive debt load.

Anxiety about inflation has fueled bids for Treasury Inflation-Protection Securities, or TIPS, a class of U.S. government bonds whose returns keep up with the pace of inflation. TIPS are among the best-performing fixed income assets so far this year.

The $513 billion TIPS market has staged a comeback this year after a dismal 2008, when investors stampeded into cash and regular Treasuries in reaction to the credit crisis and fears over the economy slipping into deflation.

"You have deflation fears abating and risk appetite returning," said Michael Pond, a Treasury and TIPS strategist with Barclays Capital in New York.

The break-even, or the yield difference between 10-year TIPS and 10-year Treasury notes, grew to 1.92 percent early Monday afternoon, 10 basis points wider than late Friday.

TIPS break-even, which serve as a proxy for the market's inflation expectations, have steadily expanded since last fall, when they collapsed in the wake of the demise of Lehman Brothers.

The 10-year break-even are running close to the year-to-year reading of the core rate of personal consumption expenditure, the Federal Reserve's preferred inflation gauge.

Earlier Monday, the government reported the core PCE was up 1.9 percent in April from a year ago, higher than expected, compared with a 1.8 percent year-over-year increase in March.

"You continue to have upward surprise on inflation data," said Barclays' Pond, citing Monday's PCE figures.

Rising prices of oil and other commodities will keep exerting upward price pressure unless the nascent signs of stability fade, analysts said.

On Monday, oil rose more than 2 percent, above $68 a barrel, touching a near seven-month high. Gold has been flirting with a record of $1,000 an ounce mark since late February.

TIPS COMEBACK

Since March, investors have been paring their safe-haven holdings in cash and government bonds in favor of riskier and higher-yielding assets such as stocks and corporate bonds on evidence the economy has stabilized.

More investors are turning their focus to rising prices of oil and other goods as global demand shows signs of picking up. They are also pondering the long-term inflation effect from the government's borrowing to finance its economic and financial bailouts.

The U.S. Treasury is expected to print $2 trillion in new debt this fiscal year.

In response, investors are expecting higher inflation, and TIPS have reaped the benefits of this shift in market focus.

In May, Barclays Capital's TIPS total return index rose 2.1 percent, compared with a 1.01 percent drop on its Treasury index. On a year-to-date basis, its TIPS index is up 5.7 percent versus a 4.1 percent drop in its Treasury index.

Only junk and municipal bonds have performed better than TIPS in the first five months of this year, according to Barclays Capital. (Reporting by Richard Leong; Editing by Dan Grebler)