ECB cash trumps downgrades to drive euro bond gains

LONDON Wed Feb 1, 2012 8:50am EST

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LONDON Feb 1 (Reuters) - Euro zone government bonds made healthy gains in January, despite spectacular downgrades, fuelled by banks flush with cheap European Central Bank cash rather than by long-term commitments from asset managers.

As a whole, euro zone government bonds returned 1.68 percent in January, according to an index compiled by Citigroup. They outperformed Citi's World Government Bond Index which returned just 0.67 percent.

Within the euro zone index, Ireland was by far the best performing, delivering returns of more than 8 percent, followed by Italy and Spain -- which gained 5.7 percent and 2.4 percent respectively. The exception was Portugal, whose rating was cut to junk by Standard & Poor's: It lost 14.7 percent in January.

The Citi numbers tally with total return data from Thomson Reuters, which shows Italy and Ireland both delivering returns of over 8 percent.

Much of the boost is laid at the door of the ECB, which lent 489 billion euros to banks in a three-year money auction in December at initial rates of just 1 percent.

"The ECB is determined to get the cost of Italy's debt servicing down. Italy is solvent and has primary surplus, and very different from Greece or Portugal," said Percival Stanion, head of asset allocation at Baring Asset Management.

Barings has bought 350 million pounds of Italian bonds this week on a purely tactical view that the ECB's operations have pushed back the timing of the next stress point in the crisis.

"There is a comprehensive commitment to keep Italy in the euro zone. People will feel the strain of being underweight Italy."

The gains in euro zone bonds come despite a series of downgrades by ratings agencies.

Fitch downgraded the sovereign credit ratings of Belgium, Cyprus, Italy, Slovenia and Spain on Jan. 27, indicating there was a 1-in-2 chance of further cuts in the next two years .

Earlier in January, Standard & Poor's downgraded the credit ratings of nine euro zone countries, stripping France and Austria of their coveted triple-A status, and pushing struggling Portugal into junk territory.

EXPLOITING CARRY

Banks can essentially borrow at 1 percent and buy government bonds from troubled euro zone sovereigns, exploiting the difference in yields which could amount to more than 400 basis points.

Barclays Capital estimates banks invested about 50 billion euros of the cheap ECB loans this way. It also expects a similar auction -- known as LTRO -- in February to lend out some 250-350 billion euros.

"The LTRO has pushed down all short-term interest rates close to zero, leading to a certain 'grab-for-yield' across all money markets," the bank said in a note to clients.

But Barclays is sceptical the demand will continue.

"With two-year yields in Italy having halved since mid-November and now standing at around 3.5 percent we think the bulk of that rally is behind us," it said.

(Written by Natsuko Waki. Editing by Jeremy Gaunt.)

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