April 19, 2013 / 12:20 PM / 4 years ago

EURO DEBT SUPPLY-Italy investors see value despite rising risks

* Italy funding outlook secure despite rising borrowing

* Investors look past political crisis, attracted by yield

* New elections pose risk, but ECB backstop wins confidence

By William James

LONDON, April 19 (Reuters) - Investors are expected to keep buying Italian bonds despite the country's prolonged political crisis and the recent increase in its borrowing needs, highlighting how a search for yield is trumping fundamental risks.

On Friday, efforts to elect a president in Rome failed, underscoring the fissures preventing Italy forming a government, and earlier this week Italy's debt agency said the country needs to borrow 10 percent more than planned in 2013.

Despite this, Italian bonds continue to rally, and few are expecting debt auctions due at the end of the month to show signs of slowing demand.

"Markets continue to be unfazed by the chaos in Italy," said Nicholas Spiro, managing director of Spiro Sovereign Strategy. "A 40 billion euro ($52 billion) increase in the country's funding a year ago would have been unthinkable, it would have posed a severe challenge."

Instead, backed by the European Central Bank's longstanding promise to support struggling states and a glut of freshly-printed stimulus money from Japan and the United States, euro zone markets have become dominated by a search for returns.

"Investors, including ourselves, have largely looked through the political uncertainty," said Nicholas Gartside, International Chief Investment Officer for Fixed Income at JPMorgan Asset Management which manages $1.4 trillion.

"The challenge is growth, and ultimately the country does need structural reform, but if you look at the riskiness from a bondholder perspective we think it's limited and the bonds are attractive."

Italian 10-year bonds pay an interest at 4.23 percent , down 50 basis points percent from a month ago, but still offer a return almost 3 percentage points higher than that available on equivalent German debt.

Traders said the country's deep and liquid debt markets, which make trading Italian bonds cheap and easy, have helped made it attractive relative to other high-yielding sovereigns in the euro zone.

UPCOMING AUCTIONS

Banks expect Italy to issue five and 10-year bonds at its scheduled auctions on April 29, and despite Rome's political strife, few see anything in the near term that could affect bidding at the sales.

"Demand has been very strong. That could slow down a bit but we don't expect a marked risk for Italian auctions at this stage," said Norbert Aul, strategist at RBC Capital Markets.

Those looking for a trigger that could arrest the divergence between falling bond yields and rising risks look to the longer term - particularly if Italians are asked to return to the polls in order to elect a majority government.

"What the market is most concerned about - what would trigger a very sharp correction - is if we went into another election and it became clear that Bepe Grillo's party was going to win," Spiro said.

Victory for Grillo's anti-establishment 5-Star Movement could throw the country's reform agenda into disarray and unnerve investors, Spiro said.

However, while short-term volatility could increase, any investors choosing to ditch Italian bonds would be offset by others who have faith in the ECB's commitment to keep struggling states afloat buy buying their bonds if needed.

With that backstop in place, JP Morgan Asset Management's Gartside said he was comfortable to hold more Italian paper than recommended by his investment benchmarks - effectively a bet that yields would grind even lower.

"We've had these positions for a while, pre-election, and on any kind of weakness we'd be more include to add to them rather than to sell," he said. ($1 = 0.7644 euros)

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