Worries over Banco Espirito Santo probe lift Portuguese yields
* Luxembourg to probe Espirito Santo holding firms
* Portuguese bonds underperform euro zone peers
* Euro zone inflation steady at 0.5 pct in June (Updates prices, adds fresh comments)
By Marius Zaharia
LONDON, June 30 (Reuters) - Portuguese government bond yields rose on Monday because of uncertainty about the country's largest bank, whose shares plunged as Luxembourg justice authorities launched a probe into three of its holding companies.
Finance Minister Maria Luis Albuquerque said Banco Espirito Santo was well-capitalised and the government saw no threat to financial stability and public accounts.
Nevertheless, bond traders said the sell-off in the bank's shares led some cautious investors to take profits on the recent rally in Portuguese government bonds.
Selling pressure in the bonds also came from investors who did not want to dump the bank's shares or bonds into a nervous market and preferred to hedge their losses by betting on a rise in government bond yields, traders said.
Ten-year Portuguese bond yields rose 8 basis points to 3.67 percent, having hit their lowest since late 2005 around 2.25 percent earlier this month. Portuguese bonds underperformed their euro zone peers.
"There are these issues regarding Banco Espirito Santo ... and that made the market a bit nervous and some people used this as a reason to take profits," said Gianluca Ziglio, a strategist at Sunrise Brokers.
The bank's shares were last 9 percent lower, having traded more than 10 percent down earlier.
Junk-rated Portugal successfully completed its bailout deal in May and has returned to the bond market this year with regular debt auctions which have been well bid. The rejection of some budget cuts by the constitutional court earlier this month caused only brief selling pressure in the market.
Some traders expected the market to continue to weather negative news. They said that the large moves in Portuguese yields did not necessarily reflect a panicky market and a higher risk premium would eventually attract new buyers.
"Because of the ratings most of the Portuguese bonds are held by hedge funds, which are not natural holders," one trader said. "So when the market turns, it turns quickly because it is also less liquid than other markets."
Elsewhere, German yields fell after data showed euro zone inflation at 0.5 percent in June. Some investors expected a higher number after above-forecast German price growth data on Friday.
Inflation is running well below the European Central Bank's target of just under 2 percent and any lower-than-expected reading sparks speculation that the central bank may be forced to ease monetary policy further.
The central bank cut its interest rates earlier in June and promised more liquidity to banks via long-term conditional loans called TLTROs. It is expected to hold policy steady at its policy meeting on Thursday but give more detail on the TLTROs.
In an interview broadcast on Sunday, Executive Board Member Yves Mersch said the ECB saw no acute risk of deflation, but it did see a long period of low price growth ahead.
German 10-year Bund yields were last 1.2 bps lower at 1.247 percent.
"After last week's higher-than-expected numbers from Germany, there might have been some expectations of a higher number in the markets," said Suvi Kosonen, an analyst at Nordea. "(But) After the significant easing package from early June, the ECB is unlikely to react." (Additional reporting by Emelia Sithole-Matarise; Editing by Toby Chopra)