* Italian linkers to re-enter key bond indices end-March
* Spanish bonds make their debut in late March
* French linkers seen as main loser as index weighting falls
* ECB QE buying revives demand for inflation-linked bonds
By Emelia Sithole-Matarise
LONDON, Feb 12 (Reuters) - Italian inflation-linked bonds, which lost favour when they were dropped from key bond indices at the height of the debt crisis, are expected to outperform in coming months after getting back into the indices.
Demand for the Italian bonds and for their euro zone peers has picked up since the European Central Bank announced in January a quantitative easing programme to revive inflation and boost growth.
The Italian bonds, called linkers, are expected to be reinstated to Barclays' World Government Inflation-Linked (WGILB) and Euro Government Inflation-Linked (EGILB) bond indices from March 31 after Barclays lowered its minimum credit- rating requirement to Baa3/BBB- from A3/A-.
Spanish linkers, about a tenth of the market value of Italy, will also join the indices -- among the most widely tracked by bond investors.
Both Italy and Spain are rated Baa2, based on the middle rating by Moody's, Standard & Poor's and Fitch. Analysts say that even if Moody's downgrades Italy on Friday in a scheduled review, it will still be eligible.
Italian bonds, or BTPeis, fell out of the indices in mid-2012 after Moody's cut Italy's ratings to two levels above junk, prompting index-tracking investors to dump the debt.
Inflation-linked euro zone bonds have been climbing back from historical lows in recent weeks after the ECB included them among the sovereign bonds it might buy. But the reinstatement of Italian linkers has put them on track to outperform their French and German peers.
The BTPei market "finds itself with potential buying from the ECB and re-inclusion in the most widely followed inflation index," said Jamie Searle, European and UK inflation strategist at Citi. "It's definitely a double whammy. We would expect real yields to move lower and breakevens to widen as well."
Investors in linkers get the annual coupon, which is usually lower than on a nominal bond, plus the annual rate of inflation, either in the domestic or euro zone economy. The difference between nominal and inflation-linked yields is called the breakeven rate.
According to Barclays Capital, Italian bonds are projected to represent 33 percent of the EGILB index by market value. France's top-ranked weighting -- which shot up after Italy dropped out -- will fall to 47.3 percent from 73.4 percent.
Italy will be the fourth-largest market in the WGILB and Spain the 10th largest out of 12 eligible global linker markets.
Real yields on Italian 10-year inflation-linked bonds have dropped to 0.72 percent since the start of the year from 1.30 percent. They are expected to keep falling as investors whose portfolios track the index look to buy.
Some of the fall in real yields matches a rise in demand for regular peripheral euro zone bonds. Investors are seeking higher returns as yields on top-rated bonds are falling as the ECB prepares to buy.
Real yields on 10-year German and French linkers have turned negative, to around -0.68 percent and -0.38 percent respectively. That could give overseas investors who snapped up French linkers -- the most liquid in the euro zone -- another reason to switch into Italy.
"The Italian and Spanish curves have positive real yield," said Yanick Loirat, a portfolio manager at BNP Paribas Asset Management. "When you see that the French curve has negative real yields, if you hold your position it is difficult to make a gain."
Estimates vary of how much cash might flow into Italy and out of France, because of the uncertainty of the size of the index-tracking funds. Citi assumes index-related demand for Italy may be as much as 16 billion euros and sales of France around 13 billion euros.
French outflows are expected to be offset by ECB purchases in coming months of around 18 billion euros. But Italy still emerges the winner with expected QE inflows of 10 billion euros.
"The total inflow into BTPei won't happen in one go," said Searle at Citi. "However, it does create a very supportive backdrop for that market, particularly when you overlay the broader context, which is we expect QE buying to be supportive for peripheral yields and drive further spread compression."