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NEW YORK (Reuters) - Inflation in the United States has been tame in the last few years, but there's been just enough for bonds linked to the rise in prices to beat most other bond investments - a trend that should continue in 2013.
Bonds linked to inflation, known as Treasury Inflation-Protected Securities (TIPS), will likely deliver less impressive returns in 2013 with their yields stuck in negative territory, but big bond investors say don't bet against them yet because of the Federal Reserve.
TIPS are on track to beat Treasuries for a fourth straight year, the longest such streak since 2001 to 2005. In the past three years, TIPS managed an average annual return of 10.4 percent, surpassing the 4.0 percent average return on regular Treasuries, according to Barclays.
"It's going to be a struggle to repeat the performances we have seen the last three years, but I still see tremendous value in owning TIPS as opposed to other fixed income assets because all rates are low," said Martin Hegarty, co-head of BlackRock's inflation-linked bond portfolios in New York.
The U.S. central bank, led by Chairman Ben Bernanke, has been pumping cash into bonds in a bid to reduce high unemployment and boost economic demand.
It has bought billions in bonds each month since late 2008, causing its balance sheet to balloon to $2.86 trillion. Because of that, virtually all U.S. interest rates are hovering at historic lows.
"They have drawn long-term interest rates lower and they will hold them there until there's a sustained growth trajectory," said Gemma Wright-Casparius at Vanguard in Malvern, Pennsylvania, who runs the $44.8 billion Vanguard Inflation-Protected Fund (VIPSX.O), the biggest U.S. TIPS mutual fund.
The Fed is widely expected to decide to continue its bond purchases at its policy meeting next week.
The Fed's bond buying has elevated prices of oil, food and other commodities. This has generated enough inflation to allow TIPS - whose principal and interest payments adjust against the U.S. Consumer Price Index - to outpace Treasuries and most other U.S. bonds since 2008.
With TIPS, most of their yields, dubbed "real" yields, have been treading in negative territory, which makes them pricey.
The "real" yields on a 10-year TIPS typically match the expectations for long-term U.S. economic growth, which had averaged 3.5 percent to 4.0 percent before the Great Recession.
But the sluggish growth rate during the current recovery and the Fed's quantitative easing have skewed the 10-year TIPS yield, so it does not reflect traders' U.S. growth outlook.
So how have TIPS, with their negative yields, managed to generate higher returns than most other U.S. debt with the exception of corporate bonds?
Thank the Fed for propping up inflation expectations
Investors use so-called breakeven rates to express their inflation view. Breakeven rates represent the gap between the "real" yields on TIPS and the yields on regular Treasuries.
On Thursday, 10-year inflation expectations stood at 2.46 percent, higher than the year-over-year inflation rate of 2.2 percent in October. With the Fed buying a tremendous amount of government bonds, it has boosted expectations for future inflation.
As long as the CPI remains positive, the government will provide positive adjustments on principal and interest payments on TIPS, boosting their overall returns.
How much inflation adjustments will enhance TIPS returns going forward is impossible to predict with certainty, but it is estimated that at least a third of their future return will be tied to CPI adjustments.
Even though the TIPS sector has become pricey, the longest TIPS maturities still have potential for their yields to fall further. Fund managers say investors have not fully priced in the inflation risk from the easy monetary policies that the Fed and other major central banks have pursued.
"If real yields go lower, the 30-year will lead the charge because there is a significant grab for duration," BlackRock's Hegarty said.
The 30-year TIPS breakeven rate is 2.47 percent, essentially the same as the 10-year TIPS rate, suggesting traders are not demanding additional inflation premiums for another 20 years.
Buying "30-year breakevens make a lot of sense. There should be more of a risk premium out given how accommodative Fed and global monetary policy is," said Bill Irving, a portfolio manager with Fidelity Investments in Merrimack, New Hampshire, who oversees about $45 billion in bonds.
While TIPS fund managers interviewed were confident TIPS will continue to beat Treasuries next year, they were less so about the overall return of TIPS.
"I won't say it's the end of the run for TIPS. I think there is still a decent potential to outperform Treasuries, but I think both of them have the risk of posting negative returns," Fidelity's Irving said.
If U.S. growth and inflation were to accelerate due to say an orderly resolution of the "fiscal cliff" dispute over the federal budget, all bonds including TIPS could become less appealing as investors look to stocks and other growth-oriented investments.
Rather than owning a traditional TIPS fund, investors might consider other bond alternatives. AllianceBernstein offers a "TIPS-plus" portfolio (ABNAX.O) that is a mix of TIPS, corporate and other types of bonds. This strategy offers inflation protection but reduces the interest-rate risk on TIPS if yields spike higher.
Another approach to reduce interest-rate risk on TIPS is beef up on short-dated issues. While shorter-maturity TIPS promise lower returns, their value erodes less as yields rise.
Reporting by Richard Leong; Editing by Steve Orlofsky