* Cyprus says may issue bonds as soon as this month
* Hunt for yield likely to ensure smooth sale
* Cyprus Europe's last bailed-out state to return to markets
By Marius Zaharia
LONDON, June 13 Cyprus is preparing to sell bonds to yield-starved investors in the next few weeks, making a return to markets that looked very distant just a year ago when it was bailing-in bank depositors and imposing capital controls.
Still mired in recession, and with its credit ratings deep in junk territory following a debt exchange last year that ratings agencies classed as a default, the island hired five banks this week to oversee a planned bond sale.
That would mark the fastest comeback to markets of any of the euro zone countries that were forced to seek international aid as a debt crisis engulfed the currency bloc. It would also take place while capital controls are still in force, although Nicosia says it aims to lift them by the end of the year.
With interest rates in developed countries at historic lows and investors grabbing anything that offers even a tiny pick-up in yield, the sale is expected to be a success.
"Now is the best time for Cyprus to establish itself in markets. Push, push, push for yield," said Dan Fuss, vice chairman of Kansas City-based Loomis Sayles & Company.
The returns on offer are hard to match.
Cyprus's benchmark February 2020 bonds yield 4.75 percent , well above the 2.8 percent offered by similar bonds of Portugal, which recently exited its bailout, and the roughly 2 percent yield on Spanish and Italian debt.
Yields on top-rated bonds are even lower, which pushes investors to buy riskier assets to maximise returns.
In April, twice bailed-out Greece sold five-year bonds yielding just under 5 percent in one of the fastest returns to commercial borrowing of a state that had defaulted on debt.
Last week, the European Central Bank cut all its policy rates and promised more liquidity for banks in a move that fostered even more demand for high-risk assets.
"The yield ... is attractive. That was the case before the ECB last week and the tone has improved since then," said Robert Tipp, chief investment strategist at Newark-based Prudential Fixed Income, which holds Cypriot and Greek debt.
Such borrowing costs look appealing for Cyprus as well. Higher-rated states in the euro zone had to pay much more to sell their debt only two years ago.
Politically, the market return would be an endorsement of the island's resolve in sticking to the tough terms of its rescue package, while Brussels is likely to offer it as proof that its bitter austerity medicine has worked.
Cyprus has constantly outperformed expectations since it signed the 10 billion euro aid deal in March 2013.
Its economy is expected to contract by 4.2 percent this year, less than the 4.8 percent initially expected, and some, such as local consultancy Sapienta, see the decline in output at closer to 3 percent.
The island has also gradually reduced capital controls in the past year, although investors with money in some Cypriot banks still cannot move cash abroad without prior approval.
The restrictions do not affect investments in government bonds directly, but the fact that money cannot move freely in and out of the country is usually a big deterrent for any foreign investor.
Not this time, though.
"At the moment I don't think investors care a lot about capital controls ... market prices suggest they're likely to be able to issue," said Michael Michaelides, rates analyst at RBS.
THE GREEK COMPARISON
There are no concrete details about what kind of bonds may be on offer, with the roadshow yet to start.
But analysts reckon a five- or even a 10-year might be feasible, while the buyers are likely to be the same ones who bid for the Greek bonds: a large part will probably go to British- and U.S.-based hedge funds.
Hans Humes, chief investment officer at Greylock Capital, who bought Greece's bonds, said he was interested in Cyprus.
"What Cyprus has over Greece is that they didn't do a sovereign debt restructuring," said the New York-based veteran of troubled debt markets.
Greece's new bond now yields around one percentage point less than when it was issued - something which may encourage investors to buy. But beyond any profits it may bring, a Cypriot market comeback will have a deeper meaning.
"For the country itself and for the people that have gone through the crisis it will show that if you keep persevering and do the right things you will be able to access the market again," said Stuart Culverhouse, chief economist at distressed debt brokerage Exotix in London.
"It would also be seen by Brussels and other European capitals as an endorsement of the actions they have taken." (Additional reporting by Michele Kambas; Editing by Catherine Evans)