EURO GOVT-Political risk lift Spain, Italy bond yields

Mon Feb 4, 2013 12:03pm EST

* Spanish and Italian yields rise as political risks grow

* 2013 rally in peripheral bonds reaching stretched levels

* German Bunds rebound as peripherals suffer

By Emelia Sithole-Matarise and William James

LONDON, Feb 4 (Reuters) - Spanish and Italian bond yields rose on Monday as mounting political uncertainty in both countries rattled investors and threatened this year's strong rally in higher-yielding euro zone debt.

German Bunds recouped some of last week's losses as the fresh selling in the euro zone's weaker issuers, which hoisted Spanish 10-year yields to a six-week high, drove investors back into the region's lowest risk debt.

Appetite for periperhal euro zone debt soursed as Spanish Prime Minister Mariano Rajoy faced calls to resign over a corruption scandal, while in Italy the growing popularity of former premier Silvio Berlusconi was a worry for investors in the run-up to elections this month.

"We're basically paring almost all the gains we had in January...We saw some selling, not from domestics...it's the foreign investors who are selling. There's a bit of fear that Berlusconi is gaining a bit of traction as he is recovering in the polls. " one trader said.

"For me it's nothing to worry about yet but the problem is the market went into month-end overweight in Italy and Spain and so they found themselves a bit underwater with these events coming and also the Rajoy story," he added.

Spanish 10-year government bond yields rose as much as 24 basis points on the day to 5.45 percent, their highest since mid-December, while Italian yields jumped 15 bps to 4.48 percent.

Peripheral debt has enjoyed a strong start to the year, which saw Italian yields plumbing two-year lows aided by the easy supply of cash from central banks and a promise from the European Central Bank that it will step in and buy bonds of struggling states if necessary.

CUTTING BACK ON RISK

Upcoming debt sales from Italy and Spain in coming weeks against a backdrop of decreaasing coupon and bond repayments - which usually get reinvested into the new issuance - were likely to keep upward pressure on yields, some strategists said.

"It makes sense to take profits on convergence strategies. We've had a fantastic run so far. And there are a couple of headwinds ahead of us in the form of politics in Italy," said Padhraic Garvey, head of investment grade strategy at ING.

"It's very heavy in terms of supply in the next couple of weeks and there're no coupons, redemptions which makes it feel a little bit heavier."

Commerzbank strategists said the time was right to start cutting back investments in peripheral debt as current low yield levels tested technical supports and the Spanish political risks mounted.

"Uncertainty from the accusations (against Rajoy) has the potential to weigh on sentiment, giving investors second thoughts about overweight positions in the periphery in general and Spain in particular at current spread levels," they said in a note to clients.

Rajoy denies any wrongdoing.

German Bund futures, often used as a hedge against a flare-up in the region's weaker sovereigns, rose as much as 63 ticks on the day to settle at 142.64 while cash 10-year yields ended down 6 bps at 1.62 percent.

RIA Capital Markets strategist Nick Stamenkovic, however said any rally in Bunds was likely to be used by some investors as a chance to sell but the potential for another major selloff remained limited due to the sheer scale of recent falls.

The 10-year German yield has risen some 32 bps from levels seen on the final trading session of 2012.

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