* Australian state debt offers attractive yields; high ratings
* Investors see scope for further strong performance
* Banks seen as captive buyers because of regulatory demands
* Australian federal bond supply to outpace state issuance
SYDNEY, March 18 Bondholders look set for windfall gains as Australian states sell assets from hospitals to ports and power stations to reduce their substantial debt and lower steep funding costs.
The windfalls will come as states redeem large numbers of bonds, making the remaining debt on issue more valuable and underpinning prices in the secondary market.
Reducing their debt levels could also see some states winning a credit-rating upgrade, instantly granting bondholders a healthy bonus as bonds rise in value.
Australian investors have snapped up much of the A$200 billion ($179 billion) in state bonds on issue because it is highly-rated debt that yields about twice as much as bonds issued for example by Spain - one of the weakest and most debt-laden European economies - yet carries only a fraction of the risk.
Five-year Australian dollar bonds issued by AAA-rated New South Wales and Victoria, the nation's two most populous states, pay between 3.7 percent and 4 percent. This compares with a mere 2.0 percent offered by Spain's euro-denominated debt rated some nine notches below at BBB-minus.
Australian states are selling "non-critical" public assets to lower their debt and reduce their funding costs, which will make big planned investments in infrastructure more affordable.
"Asset sales will improve the states' overall debt ratio even as they reinvest some of the proceeds in new projects," said Anthony Kirkham of Western Asset Management, which invests A$18 billion in fixed-income securities. "They are moving in the right direction."
Investors are heartened by states' efforts to put their fiscal houses in order, prompted in part by Standard & Poor's cut in the ratings of the resource-rich states of Queensland and Western Australia to AA+ and South Australia to AA because of falling revenues. S&P also placed New South Wales's top rating on negative outlook.
Simon Warner, head of fixed-income at AMP Capital, one of Australia's largest fund managers with A$140 billion globally, hopes debt reduction will return AAA ratings to Queensland and Western Australia.
The five largest states plan to cut their combined funding needs by two-thirds to below an annual A$10 billion in total by June next year on a cash flow deficit basis, UBS data shows.
By contrast, the federal government plans to double its debt issuance to A$42 billion in the same period. Triple A-rated Australia has A$277 billion of bonds on issue.
Increased issuance has seen the yield gap between sovereign and state bonds narrow considerably since 2007/08 when it was around 115 basis points. Western Australia's 10-year debt was last at 58 basis points over federal government bonds with some seeing scope for further contraction to around 40 bps over.
A key factor underpinning state debt, also known as semi-government debt, is demand from local banks scrambling to find highly liquid assets to meet prudential requirements.
"We are selectively adding semi-government bonds to our holdings, particularly in the 6- to 9-year part of the curve where value is more attractive," said Nigel Bradshaw, a senior dealer at ING Bank Australia, which has a balance sheet of A$50 billion.
Still, some economists warn that regional governments have disappointed before, largely because politics has got in the way of reform.
"The budgeted fiscal consolidation requires a sustained period of spending restraint that has never been achieved, or at least not in the past decade," said Matthew Johnson, a rate strategist at UBS. "Promising to do it is one thing. They need to prove they can do it." ($1 = 1.1135 Australian dollars) (Editing by Eric Meijer)