Spain economy woes seen curbing bond gains vs Italy
* Spanish/Italian 10-year yield gap near tightest in a year
* Restricted scope for further narrowing
* Preference for Spain limited by economic, political risks
By Ana Nicolaci da Costa
LONDON, March 14 (Reuters) - Spanish bonds' outperformance of Italian debt may be running out of road as some investors look beyond political deadlock in Italy and conclude that Spain remains the euro zone's bigger long-term problem.
The premium investors demand to hold 10-year Spanish debt rather than Italy's has shrunk more than 50 basis points to just 16 as uncertainty in the wake of an inconclusive Italian election last month prompted investors to dump local debt, sometimes in favour of Spanish bonds.
But, analysts say, Spain's borrowing costs have limited scope to fall below Italy's and the trend could even reverse.
"Near term the political uncertainty is weighing on (Italian) BTPs for sure but, structurally, I think that Italy is still in a better condition than Spain," Patrick Jacq, European rate strategist at BNP Paribas said.
"For me, this means that the potential for the compression is now very, very limited and at some stage investors will prefer to shift from Spain to Italy, if they have to shift."
Italy and Spain, the euro zone's third and fourth largest economies respectively, were both seen as potential flashpoints in the euro zone debt crisis until European Central Bank chief Mario Draghi pledged last July to save the euro.
Italy contracted by more than Spain in 2012 and it has the bloc's second highest public debt relative to the size of the economy after Greece, making it particularly vulnerable to a rise in borrowing costs.
But its public deficit in smaller than that of Spain which struggles with an overextended banking system, regional debt and one of the highest unemployment rates in the European Union.
"The key difference is sustainability of government finances," Rabobank senior market economist Elwin de Groot said. "Italy has a much stronger private sector - corporate and household sector. That's a big difference with Spain where the private sector is very indebted and unemployment is really high."
The end of the property boom hit Spanish banks hard -- ultimately forcing the government to seek European aid for its lenders last year.
Spain is not immune to political risk. Earlier this year, Spanish Prime Minister Mariano Rajoy faced calls to step down over corruption allegations that are still being investigated.
The two countries' 10-year yields moved in sync for most of the past year until the correlation broke down in mid-February.
Even though the ECB's bond-pledge has lured yield-hungry foreign investors back to both markets in recent months, they are more likely to favour Italy's debt market over Spain's because it offers greater liquidity and a better credit rating, Elaine Lin, a rates strategist at Morgan Stanley, said.
Against this backdrop, analysts see little space for the premium investors demand to hold 10-year Spanish debt versus Italy's to narrow further.
"There is a bigger short-term risk that Italy becomes the spark for another crisis than there is Spain. (But) longer-term, Spain is probably more dangerous from (the point of view of) pure, underlying fundamentals of the economy," Gary Jenkins, director of Swordfish Research said.
"Spanish yields could probably go 10 to 20 (bps) through Italy if the Italians are unable to form a government. I think at some stage though there's got to be some pull-back just because if investors were to start doubting Italy then eventually you would get contagion to Spain."
Without a government, Italy would not be able to meet the conditions to activate the ECB bond-buying programme, which has supported demand for its bonds and kept its borrowing costs low.
During Italy's last political crisis in late 2011, when former premier Silvio Berlusconi was hounded from office, 10-year Spanish yields were as much as 190 bps less than Italy's.
The JPMorgan Global Fixed Income team, which manages $154 billion of assets, put an underweight position on Italy and overweight on Spain against government bond benchmarks around the time of the Italian vote, portfolio manager Iain Stealey said.
Their funds would only unwind it if Spain began to look too expensive versus Italy.
"The spread has moved a long way, you need to take that into account. We are happy to maintain that position," he said.
"If you do see the Spain-Italy (10-year yield spread) moving another 50 bps in favour of Spain, we would think the trade has run a long way," he said.
Some investors are content to stick with both.
Peter Wilson, senior portfolio manager at First International Advisors, a subsidiary of Wells Fargo Asset Management, preferred buying the periphery versus Germany.
He said the fund had maintained positions in both Italian and Spanish bond markets throughout Italy's election.
"We chose to keep both positions for diversification and our position hasn't changed. We are still comfortable holding both," Wilson said.
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