Path ahead rocky for riskiest euro zone government bonds

LONDON (Reuters) - Investors' love affair with riskier euro zone government bonds has cooled and with the European Central Bank looking to unwind its liquidity support, rekindling that relationship will not be easy.

With less of the cheap central bank money which has boosted many asset classes around next year, economic fundamentals will become the key guide to which bonds to buy, especially as debt supply is set to rise from already elevated levels in 2009.

Investors got an early taste of how fundamental jitters can unsettle these bonds, which offer a yield premium over benchmark German Bunds, as they took a hit in the last few days when risk aversion rose on fears of a Dubai debt default.

That means a repeat of the stellar performance of these so-called peripheral euro zone government bonds is very unlikely in 2010 as investors fret about the fiscal health of the weaker euro zone economies.

The weakest are likely to face higher borrowing costs and run increased risk of credit rating cuts, analysts say.

From February to late this year, some of the yield premiums over Bunds dropped by as much as 200 basis points as a recovery in risk appetite fueled demand for higher-yielding assets.

The 10-year Greek yield spread over Bunds crunched in to 100 basis points by August from more than 300 in February. The spread has since rewidened to around 200 basis points, leading other peripherals wider.

For a graphic comparing Greek and Irish bond spreads over Bunds and Dubai's five-year credit default swap, click on:

here

Greece's chronic fiscal woes and frequent revisions of statistical data, which have hurt its credibility, came to the fore after revised figures two weeks ago showed the economy slipped into recession at the start of the year.

"While the early part of 2009 was characterized by significant spread market volatility, this was subsequently swamped by the effects of abundant liquidity, which in our view has served to push some spreads to unwarranted levels," said Steven Mansell, analyst at Citi.

"We believe that a re-pricing of fundamental risk lies in store next year, although the full impact of this move is unlikely to be seen until the ECB begins to remove its aggressive liquidity provisions."

Citi is also projecting a 5.4 percent rise in euro zone issuance next year to 875 billion euros.

The ECB is likely to make its last offer of one-year funds to banks in December but the first big liquidity drain will be in June, when nearly half a trillion euros of one-year funds mature.

ECB officials have been becoming more vocal about the need to gradually unwind the extraordinary stimulus measures as the global economy recovers.

This week, ECB Council member Axel Weber said the central bank and government support has reached its limit and exit strategies cannot be deferred into the never-never.

FISCAL FOCUS

For many of the weaker members of the euro zone, this is not good news as it means their funding costs may well rise because investors will demand higher yields on their bonds to compensate for the perceived greater risk.

ECB President Jean-Claude Trichet has warned some countries in the euro zone were running the risk of losing markets' faith due to excessive deficit and debt levels.

"Investors are increasingly looking at relative fiscal positions in different (euro zone) members and that'll be an increasing theme for next year," said Nick Stamenkovic, strategist at RIA in Edinburgh.

Citi's Mansell said countries suffering from precarious fiscal positions as well as significant external financing needs were likely to be at particular risk of underperformance.

"In this regard, Greece, Portugal and Spain are likely to remain in the spotlight," he said.

Adding to the caution is the prospect of further sovereign credit ratings downgrade.

A JPMorgan analysis based on the ratio of debt to gross domestic product levels suggested rating changes were twice as sensitive to sovereign debt levels during a recovery than during a recession.

"Using current and projected debt/GDP levels we find that Spain, Ireland and Greece may suffer additional 1-2 notch downgrades by 2011," JPMorgan analyst Pavan Wadhwa said in a report.

(Graphic by Scott Barber, editing by Nigel Stephenson)