UPDATE 3-Portuguese worries hit demand at Greek debt sale, bruise periphery

Thu Jul 10, 2014 12:02pm EDT

* Portugal's worries about BES group have regional reverberations

* Greek three-year debt sale sees lacklustre demand

* Irish, Spanish sales go smoothly as markets differentiate (Adds more detail on Portugal, fresh comments, updates prices)

By Marius Zaharia and Emelia Sithole-Matarise

LONDON, July 10 (Reuters) - Concern about the health of a parent company of Portugal's largest bank hurt bonds from the euro zone's periphery on Thursday, curbing demand at Greece's second debt sale following its 2012 default.

It was the first significant episode of contagion for peripheral markets in 2014. Debt yields in those markets reached record lows in the first half of the year, helped by ultra-easy European Central Bank policies that let countries sell debt easily regardless of their ratings or economic situation.

Espirito Santo Financial Group, the largest shareholder in Portugal's Banco Espirito Santo, said on Thursday it had decided to suspend its shares and bonds, citing "material difficulties" at its parent company, ESI.

Separately, Portugal's securities market watchdog, CMVM, said it was analysing a major investment by Portugal Telecom in the debt of Rioforte, a holding company of the Espiroto Santo group.

Sources told Reuters on Wednesday that Espirito Santo was considering debt-for-equity swaps and may ask for more time to repay debts, as it grapples with the financial problems.

The government in Lisbon has repeatedly said that BES is isolated from the holding company's problems and there is no risk to public finances. However, the turmoil has led to a sharp sell-off in Portuguese government bonds and had repercussions for other markets as well.

Greece's sale of three-year bonds drew mediocre demand compared with recent offerings from euro zone peripheral issuers. Athens raised 1.5 billion euros, well below the 2.5 billion to 3 billion euros it was widely expected to achieve.

Total bids were only 3 billion euros. That looked lacklustre to many market players who are used to seeing order books several times that size at a peripheral euro zone debt sale.

Spain's Banco Popular Espanol, meanwhile, was forced to postpone the sale of contingent convertible debt citing poor market conditions, according to a lead manager on the planned deal.

Guido Barthels, chief investment officer at Luxembourg-based Ethenea, was initially interested in the Greek bond sale but was put off by what was happening in Portugal.

"It is not a good day to come to the market for Greece," Barthels said. "Given what's happening in Portugal, it does not make a whole lot of sense to touch that."

Yields on Portuguese 10-year bonds rose 21 basis points to 4.01 percent, dragging their peripheral peers with them. Greek yields were 20 bps higher at 6.32 percent. Spanish and Italian yields rose 6 bps to 2.82 and 2.94 percent, respectively.

Some market participants said contagion from Portugal appeared overdone.

"We do not think the problems emanating from the BES debacle should be seen as a systemic issue for the sovereign, and feel that the contagion effects are overdone and likely exacerbated by positioning and poor liquidity," said Martin Harvey, European bond manager at Threadneedle Investments.

"Having said that, it is a reminder that peripheral nations will continue to face sporadic mini-crises due to the deep structural problems their economies and financial systems face."

DIFFERENTIATION

The Greek bond was sold at a yield of 3.50 percent, the lower end of a 3.50-3.625 percent price guidance. That is higher than those offered by all 10-year euro zone bonds apart from Portugal's.

Investors in Italian debt, for example, would have to buy a 15-year bond to get a higher yield than Greece's three-year paper. German 30-year paper offered 2.16 percent.

Market action suggested that investors were still differentiating between peripheral markets, though.

Aid-receiving Greece and Portugal, which emerged from its bailout less than two months ago, were seen as the most vulnerable. Irish 10-year yields were 2 bps up at 2.34 percent; the country saw record low borrowing costs at an auction of 500 million euros in 10-year bonds.

Spain also held a smooth sale of 1 billion euros of 10-year inflation-linked bond at an average yield of 1.46 percent.

"We've seen a very strong sale in Ireland," said Michael Michaelides, rates analyst at RBS. "The broader correlation still stands in the periphery  but now you see increasingly that when there is a particular story in one country, that market moves a lot more than the others."

That differentiation will last as long as the euro zone stays clear of any systemic risks, such as those in 2012, when Greece was on the brink of crashing out of the currency union following its default.

Greece's bond sale is a hallmark of its recovery. The country is slowly emerging from a six-year recession and is running a budget surplus before interest rate payments.

But the new bond comes with a caveat. One of the most attractive features of Greek debt before this sale was that the country had no debt to pay back for the next five years, hence no near-term financing risk.

In comparison, half of the combined debts of Italy and Spain expire in the next five years.

In the next three years, Greece will have to decide which path to take after the end of its second bailout deal with the International Monetary Fund and the European Union. It will also have to hold elections in 2016, or earlier if the fragile ruling coalition loses even more strength.

Anti-bailout leftist party Syriza did well in the May European Parliament elections and is expected to retain its support from a population deeply hurt by austerity. Bondholders prefer the predictability of a pro-bailout government. (Editing by Larry King and Anna Willard)

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