All calm for euro periphery as Fed waves engulf emerging markets

Mon Sep 2, 2013 12:05pm EDT

* Italian, Spanish debt well bid as emerging bonds sold off

* Investors take profit as Fed readies stimulus taper

* More vulnerable Portugal also seen withstanding sell-off

By Ana Nicolaci da Costa

LONDON, Sept 2 (Reuters) - Investors in high-yielding peripheral euro zone bonds are having their cake and eating it too.

Like emerging assets, lower-rated euro zone debt greatly benefited from the trillions of dollars of stimulus that central banks pumped into the financial system as investors sought alternatives to core bonds yielding next to nothing.

But it has withstood an emerging market rout fuelled by expectations the U.S. Federal Reserve is about to taper its bond buying, possibly as soon as this month.

Emerging assets took a pounding going in to September, while borrowing costs on 10-year Italian and Spanish debt have stabilised roughly in the middle of this year's ranges - underpinned in part by a European Central Bank guarantee covering struggling euro zone nations' shorter-dated bonds.

Yield spreads on emerging market bonds have widened by around 100 basis points to 370 bps over rising U.S. Treasuries since mid-May, before the Fed said it could curb bond purchases later in the year. Spreads on major periphery debt versus Bunds narrowed 20-40 bps over that period.

"Let's say you are a bond investor. If you take profit on your Spanish bonds and your Italian bonds - what do you do with your cash? You are not going to go to emerging markets at this stage," said Tanguy Le Saout, head of European fixed income at Pioneer Investments, who oversees the management of 35.6 billion euros of European fixed income.

One reason for the recent calm in the periphery is that fund managers had already been trimming exposure to Italian and Spanish debt in recent months, due to their outperformance versus German Bunds and emerging market peers.

The premiums offered by 10-year Italian and Spanish bonds over German debt have fallen more than 100 basis points since this year's peaks and hit two-year lows in mid-August. They were last higher than but not far from those levels at 246 bps and 254 bps respectively.

Emerging market bond spreads, meanwhile, have been on a rising trend. The premium offered by 10-year Turkish dollar bonds over U.S. Treasury yields has surged 145 bps since mid-May to 285 bps and the Brazilian equivalent has surged 170 bps to 270 bps over the same period.

"We reduced from an overweight position in Italy during June to a more neutral position through July following outperformance versus emerging market bonds. We were looking for a bit of a catch-up," Threadneedle Investments' Martin Harvey, who manages the 200 million euro European Bond Fund said.

The fund had been underweight Spain versus the benchmark it follows since the beginning of the second quarter, he added, also because of how far the premium versus Bunds had fallen.

Another reason for their resilience is that riskier euro zone debt is protected by large domestic investor bases in some countries, bailouts in others and overall by the ECB's bond-buying programme, which covers maturities up to three years.

Domestic investors, who tend to hold bonds for longer, own nearly 70 percent of Spain's and Italy's debt. But analysts estimate foreign investors are also in for the long haul, given the ECB backstop and the improved euro zone growth outlook.

PORTUGAL VULNERABLE?

Given the similarities between Portuguese bonds and some emerging market debt - they are high-yielding and junk-rated - some analysts see Lisbon as a prime candidate for contagion from emerging markets - though even there the risks look contained.

Olivier de Larouziere, head of interest rates at Natixis Asset Management, said the 920 billion euro Natixis Euro Sovereign fund still holds Portuguese debt, mostly short-dated, but had sold some of it during the emerging market rout.

With a domestic investor base of 47 percent, far less than that of Italy and Spain, Portuguese debt is in theory more vulnerable to foreign investor appetite than their peers.

But, thanks to its international bailout, Portugal does not have to regularly raise funds in the market, making it less susceptible to changes in sentiment than Spain and Italy.

Portugal is also not exposed to foreign exchange volatility in the same way as emerging economies.

"The difference is that Portugal has no dollar financing needs. It needs low European interest rates and you have that in place with the ECB's forward guidance," Gareth Isaac, senior portfolio manager at Schroders said. "They do have the protection of the ECB, a relatively strong currency and you also have the economy beginning to improve in Europe."

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