Worst week for Portuguese bonds highlights the Draghi effect
* Portuguese bonds suffer worst week of year on Espirito Santo worries
* But as yields tick up, buyers of Portugal debt come in
* Sell-off a reminder of toxic bank-sovereign links
By Marius Zaharia
LONDON, July 22 (Reuters) - Portuguese bonds' worst week of the year shows that even when the headlines are grim, investors will snap up peripheral euro zone debt provided the yield is right - thanks to Mario Draghi.
Two years after the ECB President promised to do "whatever it takes" to save the euro, this backstop stabilised a market that was seriously worried about the financial problems of Portugal's Espirito Santo family and what they might mean for the economy.
In the week ending July 11, Portuguese bonds suffered their steepest drop in value since September 2013. But as prices fell, investors - confident that the Draghi backstop would limit the fallout - stepped in and Portuguese bonds became proportionately the most bought government debt in the euro zone.
This underlined that while the euro zone has yet to solve some fundamental economic problems, people will buy the sovereign debt of peripheral member states such as Portugal if it offers a high enough return on their investment.
"The fact that you have plenty of accounts ... willing to buy on a weakness tells you there is still a huge appetite to buy high-yielding peripheral paper," said Jamie Searle, rate strategist at Citi.
"They are less concerned about these headlines that appear from time to time and they are more directed by the fundamental backstop, which of course is the ECB. What you are observing is that any dip in the periphery is likely to be bought."
At the height of the euro zone debt crisis, Draghi promised on July 26, 2012 that the European Central Bank would take any measures needed to save the euro zone, and later unveiled a plan to buy the debt of troubled countries under certain conditions.
Implicit in this is that if anything goes wrong with Portugal - which emerged only in May from a bailout deal with the European Union and International Monetary Fund - investors can sell their Portuguese bonds to the ECB.
Market reaction to the problems of the family that founded Banco Espirito Santo, Portugal's biggest listed lender, served as a reminder of the toxic link between heavily indebted European governments and the banks that fund them.
Policymakers have so far failed to fix this link - which was a major factor in the euro zone crisis - and this month's rout of Portuguese bonds spread to Spanish, Greek and Italian debt in the most significant episode of debt market contagion this year.
But client flow data from Citi, a representative sample of global debt markets, show how investors emerged as yields rose in the turbulent week to July 11. Buying of Portuguese bonds, adjusted for the size of the domestic market, was 2.5 times higher than in second-ranked Italy, according to the Citi data.
It was also five times larger than the buying of German Bunds, which are seen as the region's safest asset. Anecdotal evidence from traders at other banks backed these findings.
When news broke of the family's financial troubles, the price of government bonds fell, pushing yields higher, on selling in very thin volume. Once the returns on offer grew more attractive, many yield-starved investors snapped the bonds up in larger volume.
The Citi data take into account the amounts of bonds sold or bought by its clients. It does not include changes in the inventories of market makers - which buy debt when it is issued by governments and sell it later to investors - as otherwise the amounts of bonds bought and sold would balance.
Overall, Portuguese 10-year yields ended the week 28 basis points higher at 3.89 percent, having topped 4 percent at one point. Since then yields have returned to 3.72 percent.
The Espirito Santo problems are not yet over. Portugal's president warned on Monday that the fallout could affect the wider economy, while Banco Espirito Santo said it was appointing a special financial adviser to help boost its capital structure.
More broadly, many still argue that the bonds' losses, while not backed by heavy selling, show the anxiety of market participants about the euro zone's unsolved structural weakness.
Local investors, many of them banks, own almost two thirds of the government debt of Portugal, Spain and Italy. Every time concerns emerge about any of the banks, the sovereign's bonds take a hit and vice-versa.
This link has an impact beyond asset prices. Stuffed with high-yielding government debt, banks have less incentive to lend to businesses and consumers, promoting economic activity. Having willing debt buyers in the local market, governments have less incentive to reform their economies.
"It shows what a crazy financial system we have created when one small financial institution can cause such shockwaves around the world," said Gary Jenkins, chief credit strategist at LNG Capital. "It also demonstrates that European politicians who so famously said that they would break the link between banks and sovereigns have singularly failed to do so."
While the ECB's policies have made investors less worried about the damage that this dependency of banks and sovereigns can inflict, critics say they are allowing the problem to fester.
The ECB will offer up to 1 trillion euros in cheap long-term loans to banks from September in the hope that they will start to finance investment and consumption in the real economy.
But banks have the option of repaying the money with no penalty after two years even if they do not boost their lending, so some of those funds will probably end up in government debt.
"It is a bit like tying two rocks together, throwing them into a pond and hope that one would float," said Robin Marshall, a director for fixed income at Smith & Williamson. (editing by David Stamp)