Japan's inflation-linked bonds attract strong demand

Tue Oct 8, 2013 2:20am EDT

* Japan issues first inflation-linked bonds in 5 years

* Auction produces break even inflation of 1.00 percent

* Demand boosted by sweetener such as deflation floor, buyback scheme

* Domestic investors' appetite still not strong

By Hideyuki Sano

TOKYO, Oct 8 (Reuters) - Japan's first sale of inflation-linked government bonds in five years attracted strong demand on Tuesday, a welcome sign of rising inflation expectations for Prime Minister Shinzo Abe, who has vowed to revitalise the economy by ending deflation.

Yet, market players also say it is too early to declare victory for Abenomics, with the pricing of the bonds suggesting investors still do not believe Abe can boost inflation to two percent, as pledged.

"Some market players bought aggressively because it was the first time in many years. But we will have to see whether strong demand will continue," said Mari Iwashita, chief market economist at SMBC Nikko Securities.

The 17th inflation-linked 10-year JGBs (JGBi), carrying 0.1 percent coupon, was sold at a yield of minus 0.352 percent.

That was about 100 basis points, or one percentage point, less than the yield on the conventional 10-year bonds, which stood at 0.650 percent at the time of auction.

This means the return from the inflation-linked bonds would be larger than the regular bonds only if inflation over the next 10 years will be above 1.0 percent.

The gap between the two yields is thus called the break even inflation rate and seen as a gauge of investors' inflation expectations.

The strong sale came as Japan appears to have reversed deflation. Core consumer prices in August rose 0.8 percent from a year earlier, the biggest rise since November 2008, having stopped falling in May.

The auction's break even rate of 1.00 percent was about 0.10 percentage point higher than many traders had expected.

"The auction went very well. You could say that Japan has been stuck in deflation but things are changing now," said Tadashi Matsukawa, head of fixed income investment at PineBridge Investments in Tokyo.

Analysts say, however, that stripping out the effect of the two planned sales tax hikes, one in April 2014 and the other in October 2015, the auction results suggest the market expects an inflation of about 0.7 percent over the next 10 years.

That is still well below the Bank of Japan's target of 2.0 percent, reflecting doubts shared by investors that inflation is unlikely to accelerate when wages are hardly rising.

The Ministry of Finance also offered some sweeteners to investors, setting a deflation floor on the new issue and offering buyback of previously issued price-linked bonds without such a floor.

Japan suspended issue of inflation-linked bonds in 2008, when the global financial crisis plunged the country back into deflation and caused massive losses on inflation-linked JGBs.

Indeed, a big part of demand likely came from investors, many of them foreign, who wanted to get rid of old inflation-linked bonds through the buyback scheme, market players said.

In contrast, Japanese investors' appetite remained subdued.

Although some Japanese regional banks are said to have shown interest in the new issue, pension funds, a type of investor who would have wanted inflation-linked bonds to hedge their inflation-prone liability, were mostly sitting on the sidelines.

For many of them, fear of inflation may be hard to imagine as the last time core inflation was steadily above 3 percent was 1982.

"Most working age Japanese haven't really experienced inflation. They only know deflation," said a derivatives trader at a major Japanese bank.

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