July 10, 2014 / 11:23 AM / 3 years ago

Portugal's worries spread, hurt demand at Greek debt sale

* Portugal worries about BES group have regional reverberations

* Greek three-year debt sale sees lacklustre demand

* Irish, Spanish sales go smoothly as markets differentiate (Adds details of sale, quotes.)

By Marius Zaharia

LONDON, July 10 (Reuters) - Renewed concerns about the health of a parent company of Portugal's largest bank hurt peripheral euro zone bonds on Thursday, curbing demand at Greece's second debt sale following its 2012 default.

It was the first significant episode of contagion for peripheral markets this year.

Ultra-easy European Central Bank policies contained any broad sell-off in the first half of 2014, when peripheral debt yields reached record lows. That allowed those countries to sell debt easily, regardless of their ratings or economic hurdles.

Espirito Santo Financial Group, the largest shareholder in Portugal's Banco Espirito Santo, said on Thursday it had decided to suspend its shares and bonds, citing "material difficulties" at its parent company, ESI.

Sources told Reuters on Wednesday the Espirito Santo group is considering debt-for-equity swaps and may ask for more time to repay debts, as it grapples with the financial problems.

The government in Lisbon has repeatedly said that BES is isolated from the holding company's problems and there is no risk to public finances. However, the turmoil has led to a sharp sell-off in Portuguese government bonds and had repercussions for other markets as well.

Greece's sale of a three-year bond has so far been met with demand of more than 3 billion euros, according to IFR, a Thomson Reuters service. For many in the market, used to seeing order books several times that size at a peripheral debt sale, this was a lacklustre figure.

Guido Barthels, chief investment officer at Luxembourg-based Ethenea, is one of the investors who were initially interested in the sale but were put off by what was happening in Portugal.

"It is not a good day to come to the market for Greece," Barthels said. "Given what's happening in Portugal, it does not make a whole lot of sense to touch that."

Yields on Portuguese 10-year bonds rose 21 basis points to 4.01 percent, dragging their peripheral peers with them. Greek yields were 14 bps higher at 6.25 percent. Spanish and Italian yields rose 6 bps to 2.82 and 2.94 percent, respectively.

Barthels still expected Greece to be able to sell the planned amount within its initial yield guidance of 3.50-3.625 percent. That is were higher than those offered by all 10-year euro zone bonds apart from Portugal's.

Investors in Italian debt, for example, would have to buy a 15-year bond to get a higher yield than Greece's three-year paper. German 30-year paper offered 2.16 percent.

DIFFERENTIATION

Market action suggested that investors were still differentiating between peripheral markets, though.

Aid-receiving Greece and Portugal, which emerged from its bailout less than two months ago, were seen as the most vulnerable. Irish 10-year yields were flat at 2.32 percent; the country saw record borrowing costs at an auction of 500 million euros in 10-year bonds.

Spain also held a smooth sale of 1 billion euros of 10-year inflation-linked bond at an average yield of 1.46 percent.

"We've seen a very strong sale in Ireland," said Michael Michaelides, rates analyst at RBS. "The broader correlation still stands in the periphery  but now you see increasingly that when there is a particular story in one country, that market moves a lot more than the others."

That differentiation will last as long as the euro zone stays clear of any systemic risks, such as those in 2012, when Greece was on the brink of crashing out of the currency union following its default.

Greece's bond sale is a hallmark of its recovery. The country is slowly emerging from a six-year recession and is running a budget surplus before interest rate payments.

But the new bond comes with a caveat. One of the most attractive features of Greek debt before this sale was that the country had no debt to pay back for the next five years, hence no near-term financing risk.

In comparison, half of the combined debts of Italy and Spain expires in the next five years.

In the next three years, Greece will have to decide which path to take after the end of its second bailout deal with the International Monetary Fund and the European Union. It will also have to hold elections in 2016, or earlier if the fragile ruling coalition loses even more strength.

Anti-bailout leftist party Syriza did well in the May European Parliament elections and is expected to retain its support from a population deeply hurt by austerity. Bondholders prefer the predictability of a pro-bailout government.

"Of course, the markets are looking at the redemption profile and at some point this could become an issue," said Rainer Guntermann, rate strategist at Commerzbank.

"But for now, yield levels in these smaller peripheral countries like Greece look attractive and you don't have many alternatives." (Editing by Larry King)

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