June 29, 2011 / 4:20 PM / in 6 years

EURO GOVT-Greek bonds' relief rally capped by solvency doubts

* Greece wins backing for key austerity measures

* Greek yields lower as short-term default risk priced out

* Medium-term concerns remain, limiting relief rally

* German 5-year bond sale suffers amid better risk appetite

By Kirsten Donovan and William James

LONDON, Jun 29 (Reuters) - Bund prices fell and short-dated Greek debt rallied on Wednesday as Athens won parliamentary approval for a crucial package of austerity measures, reducing the risk of short-term default.

But persistent medium-term solvency concerns limited the relief and were expected to cap gains in coming sessions, even if parliament votes on Thursday in favour of legislation to implement the package.

The removal of a significant hurdle between Greece and the next instalment of funding needed to avert a default in mid-July, saw demand for the safety of German debt recede, at least temporarily.

“I don’t believe we’ll see a massive risk rally given only one hurdle of many has been cleared. The risk of disorderly default has decreased in the near-term but overall sentiment remains very fragile,” said Michael Leister, strategist at WestLB in London.

Bund futures FGBLc1 fell as much as 96 ticks to a low of 125.60, but later pared losses to settle at 125.90.

Two-year Greek bond yields tumbled by 1.7 percentage points ahead of the vote as investors priced out their worst fears of a default in mid-July.

The cost of insuring against a Greek default was unchanged after the austerity package was passed and ING models showed that investors still expect to receive only 60 percent of the face value of any three-year Greek bonds they hold to maturity.

Beyond the mid-July default risk, markets were still sceptical over how the country will stabilise its bloated debt burden, despite significant progress on an agreement with the banking sector to keep supporting Greece.

A new aid programme would involve some 30 billion euros in private-sector participation via a “voluntary” rollover of maturing debt.

However, concerns remain over whether rating agencies would class this as a default and trigger wider financial market turmoil, despite banking sources indicating current proposals coming out of France might not cause ratings to be cut into default territory.

“Clearly there is still a missing overlap between what’s needed for Greece and what’s need to avoid default ratings,” said Commerzbank strategist David Schnautz.

“From that perspective,(Greece) is far from out of the woods and markets will remain cautious about getting into risk-on trades.”

Yields on other lower-rated euro zone sovereigns were lower on the day, outperforming Bunds, but the moves only retraced some of the recent sharp rises in Portuguese, Irish and Spanish debt.

POOR DEMAND AT GERMAN AUCTION

The selloff in core debt weighed heavily on a German five-year bond sale which drew less demand than usual from investors.

The bid/cover ratio after taking into account the amount bought by the Bundesbank was just 1.1, compared with an average at five-year German auctions this year of 1.76, according to Reuters data.

“Of course this was difficult paper to sell in a bearish session, but this auction is worse than expected, as was last night’s five-year U.S. Treasury auction,” said Credit Agricole rate strategist Peter Chatwell.

“With a longer-term view, weak core five-year auctions are a good indication that the rally in core paper has run its course.”

Five-year German paper was close to its most expensive levels versus two- and 10-year paper this year after the maturity outperformed in recent weeks as markets pared back ECB rate hike expectations while the Greek debt crisis intensified.

The sale was weak despite the bond being the cheapest to deliver into the futures contract and with almost 40 billion euros of German coupon and redemption payments due on Monday. (Reporting by William James; editing by Stephen Nisbet)

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