UPDATE 2-Moody's dashes Irish upgrade hopes, cites Cyprus
* Moody's remains only agency to rate Ireland as junk
* Landmark bond sale raised hopes of upgrade
* Moody's says euro zone, bank assets weigh on rating
DUBLIN, March 28 (Reuters) - Credit agency Moody's dashed Irish hopes of an investment grade rating in the wake of its landmark 10-year bond issue, saying Cyprus' "unprecedented" bailout increased the risks associated with holding Irish debt.
Moody's, the only agency that ranks Ireland's debt as 'junk', said on Thursday that, despite the country's steady progress in regaining market access, it was maintaining its Ba1 rating with a negative outlook.
"Ireland's vulnerability to wider euro-area stresses has been reaffirmed by euro area policymakers' handling of the Cyprus crisis," Moody's said in a statement.
The crisis showed policymakers' "increased risk tolerance" and "a more uncompromising and less predictable approach to crisis management", it added.
Irish officials had hoped Moody's would at least lift its negative outlook after taking its biggest step yet this month towards exiting an EU/IMF bailout this year, selling 5 billion euros ($6.4 billion) of new 10-year bonds.
The head of Ireland's debt agency John Corrigan said at the time that the success of the auction indicated "either the market is wrong or Moody's is wrong."
Moody's Ireland analyst Kristin Lindow said there was no contradiction as market pricing was about "a lot more than just credit risk."
She said she could not say whether or not there would be an upgrade in the current year, in part because it was unclear how the broader euro zone crisis would develop.
"If there were mistakes made that lead to turbulence in the markets, Ireland specific events might not be able to counter that," Lindow told Reuters in a telephone interview.
Bond dealers said the rating affirmation was a big disappointment as many investors had priced in an upgrade but market reaction was relatively muted with the yield on Ireland's benchmark 2023 bond widening by 2 basis points to 4.28 percent at 1224 GMT.
Weakness in euro zone economies could impact Ireland's economic growth, the "fundamental issue" that will determine future ratings, Lindow said.
While resilient exports have seen Ireland's economy grow for the last two years and data last week showed consumer spending had risen in the last two quarters of 2012, figures on Thursday painted a picture of a domestic economy remaining sluggish.
On the domestic front, Moody's said the biggest risk was the continued poor asset quality of Irish banks, and their likely reluctance to provide new credit when loan demand revives, indicated that the country did not deserve investment grade.
On the other hand, a precautionary credit line from the International Monetary Fund and European Union would be "viewed positively" as it would qualify Ireland for its new bond buying programme, the Outright Monetary Transactions scheme.
Analysts said Moody's decision not to change its outlook could dampen enthusiasm about Ireland after 18 months in which bond yields have fallen from around 15 percent ago to just over 4 percent.
"Following the almost uninterrupted run of more favourable news flow on the Irish economy and sovereign over recent months, Moody's provides what might be described as a reality check this morning," said Dermot O'Leary, chief economist at Goodbody Stockbrokers.
"Ultimately, the decision is a reminder that the job is not done." ($1 = 0.7824 euros)