Fiscal woes to dog Greek bonds even if aid offered

LONDON (Reuters) - EU or IMF aid could cut the premium it costs Greece to borrow by 100 basis points, but all of the euro zone's weaker members will continue to face broadly higher funding costs until they get to grips with their fiscal woes.

Despite strong German resistance, markets hope a Brussels summit later this week could yet deliver a deal to support debt-stricken Greece that could boost its short-term prospects and ease fears a months-long crisis could spread.

It is clear, though, that investors will continue to demand historically higher premiums for the bonds of Greece and other weaker fringe states even if they can ease short-term nerves. That, they say, requires evidence of deeper spending reforms.

"We're getting into a new period where risks will be appropriately assessed based on fiscal situation," said Michail Diamantopoulos, a fund manager at Investec Asset Management.

"It's very unlikely we'll see spreads go back to the previous very low levels."

In the years leading up to the global credit crunch which erupted in late 2007, Greek 10-year bond yields traded consistently at 10 to 40 basis points above benchmark Bunds.

Hit first by the global credit crisis and then by Greece's own woes, that spread blew out to historic levels above 400 basis points earlier this year and was last at 340 basis points.

Debt market analysts say the spread could fall by more than 100 basis points from the current extreme levels if the country received help, but most do not expect it to dip below 200 basis points.

That would still point to an opportunity in the short-term to buy Greek bonds and win heavily -- if only there was any certainty about the prospects of a deal.

Markets' nerves had eased significantly earlier this month on the back of a successful bond sale by Greece and moves to formulate an actual mechanism for the European Union to provide aid.

That for now has come to nothing, however, and spreads have blown out again in the past week due to concerns that German Chancellor Angela Merkel simply cannot afford to put aside domestic opposition and back the provision of aid.

STRUCTURAL ISSUES

A funding squeeze which sees Greece needing to borrow around 20 billion euros in April and May has heightened the tension and kept it firmly under the spotlight. But other members of the currency bloc are struggling with similar burdens.

After Greece, Portugal and Ireland have the widest 10-year bond government bond yield spreads over Bunds in the euro zone, although they are nowhere near as wide as Greece.

Compared with the German Bund yield at 3.1 percent, Greece yielded 6.6 percent -- the highest in the region -- Portugal 4.4 percent and Ireland 4.6 percent.

This put the Portuguese/German yield spread roughly at 130 basis points and the Irish spread at 150 basis points.

At these levels, analysts say there is little scope for Portuguese and Irish paper to benefit even when fears of contagion from Greece's crisis diminished.

"They all have huge structural issues that are not adequately priced. A bail-out will alleviate short-term funding problems, it will not solve fiscal imbalances," said Mark Schofield, Global Head of Interest Rate Strategy at Citigroup.

Schofield said both the Portuguese and Irish spreads over Bunds might even have to widen to 150-175 basis points. For the Greek 10-year yield spread, he said it was hard to see it under 200 basis points.

In the lead up to the global financial crisis, there was hardly a spread to speak of between Bunds and many of the fringe counterparts.

In fact, investors made huge profits in all of these countries in their run up to euro zone entry by betting on a convergence of high market yields toward Bunds that was one of the conditions for joining.

"When the convergence story hit, spreads came in over time. So the best place to be was to buy this debt, ride the coupon and expect the spread tightening," said Paul Cavalier at pension consultant Mercer.

"The financial crisis highlighted the fact that there isn't such a thing as a free lunch any more."

(Editing by Patrick Graham)