LONDON Jan 8 Peripheral euro zone bonds are unlikely to reach the levels seen in the years before the global financial and regional debt crises even though their rally may have further to run.
Investors are starting to worry the market is not liquid enough and credit ratings not high enough to extend the rise in prices that started when the European Central Bank boss said in July 2012 he would do whatever it took to protect the euro.
The rally for bonds of the euro zone's most indebted countries continued last year, helped by reduced risk of a euro breakup, ECB support to banks, low inflation and an improved economic outlook.
The start of 2014 has provided another boost as banks, which loaded up on higher-rated bonds to boost their balance sheets for a year-end snapshot before ECB stress tests later this year switch back into riskier and higher-yielding debt.
Spain and Ireland, two of the countries worst hit by the debt crisis, have rarely been able to borrow more cheaply. They were emerging markets in the 1980s and 10-year yields before the euro launched in 1999 were over 12 percent.
They fell after euro entry but soared at the height of the debt crisis. Spain's 10-year yield reached a euro lifetime high of 7.5 percent in the summer of 2012 but is currently 3.8 percent, not far from 2.95 percent for the United States.
"You could soon see Spain and U.S. Treasuries both at 3.5 percent. But there's a 7-notch ratings differential there - this could change the structure of international demand for Spanish debt," said Alessandro Tentori, global head of rates strategy at Citigroup in London.
In the years immediately preceding the 2007-08 crisis these spreads were virtually zero. In the mid-1990s Irish and Spanish yields were even lower than Germany's.
But analysts say that is unlikely to happen again.
For much of the 2000-09 decade, Ireland and Spain were AAA credits, according to Standard `& Poor's ratings. Now, Spain is rated BBB- and Baa3 by S&P and Moody's, respectively. These are the lowest possible investment grade ratings and nine notches below AAA-rated Germany.
S&P and Fitch have Ireland at an investment grade rating of BBB+ but that's still seven notches below Germany, while Moody's has it at a "junk" rating of Ba1.
Many asset managers including pension funds and central banks are mandated to invest only in high-level investment grade bonds. At some point, they will decide higher yields offered by peripheral bonds don't compensate the credit risk over 10 years.
The collapse in borrowing costs has been dramatic. Ireland's 10-year yield fell to 3.26 percent on Tuesday, the lowest in eight years and only 136 basis points over benchmark German Bunds as investors rushed to buy the country's new 10-year bond.
Ireland's yield spread over Germany was almost 1,200 basis points in mid-2011. Spain's spread over bunds has shrunk by two thirds since mid-2012 and is now under 200 basis points for the first time in nearly three years.
But even though these bonds offer attractive returns, liquidity is an issue for big investors such as pension funds, insurance funds and central banks. They prefer to be in deep and liquid markets in order to better protect their investments from sharp price fluctuations.
The premium 10-year Spanish and Italian bonds offer investors over U.S. Treasuries - the most liquid and generally considered the safest investment in the world - is now less than 1 percentage point. The Irish premium is less than 50 basis points.
The more these spreads converge, the more likely it is international investors will decide the ratings, liquidity and credit risks make peripheral bonds unappealing.
"If you buy Treasuries, you know you can sell them again," said Ralf Preusser, head of EMEA rates strategy at Bank of America-Merrill Lynch in London.
In addition, the euro zone is experiencing record low inflation. While that helps keep official interest rates and market yields low, it makes it difficult for countries to bring their high debt down to sustainable levels over the long term.
Spain's outstanding debt is almost 900 billion euros, the equivalent of 93 percent of the country's annual economic output. The Irish and Portuguese bond markets are each only 143 billion euros in size but that is well over 120 percent of their respective economies.
Italy's outstanding debt is a hefty 1.7 trillion euros, about the same as Germany's. But Italy's debt load is the highest in the developed world at 127 percent of economic output and forecast to reach 130 percent this year.
Sluggish growth and low inflation makes it more difficult to ease that burden.
"Debt sustainability is by no means assured. It makes a big difference if nominal GDP growth is 2 percent or 3 percent," said Preusser.