Euro zone bond rally goes global as wary creditors return

By Jamie McGeever

LONDON, Jan 14 (Reuters) - The surge in peripheral euro zone government bonds is a global phenomenon, driven by investors around the world lured by relatively high yields in a world of low, often sub-inflation returns.

This is significant because it eases fears that the euro crisis had seen a "balkanisation" of euro bond markets, where the only real demand in some countries was from domestic banks and local investors as cross-border investment dried up.

Domestic banks are still large holders of their national sovereign bonds - a record share in the case of Portuguese banks and near record share in Italy - but are now far from alone as the region's financial system slowly heals.

Pacific Investment Management Company, LLC, or PIMCO, the world's biggest bond fund, holds its largest ever position in the euro zone periphery, and Japanese investors are buying Spanish and Italian bonds at a pace not seen for five years.

A stabilising euro zone economy and banking system saw U.S. money market funds increase their funding of European financial institutions by 11 percent in the fourth quarter of last year, according to Moody's.

Add the diminishing risk of euro zone break-up and the prospect of further action from the European Central Bank to counter extremely low inflation, and the overseas money has flowed in.

"We're overweight Italy and Spain, the most liquid markets," said Andrew Balls, head of European portfolio management at PIMCO who oversees a team which manages $400 billion.

Balls said PIMCO's position in these bonds isn't "maximum" overweight due to valuation and concerns over how these countries will reduce their debt in the coming years when economic growth is low and unlikely to accelerate meaningfully.

In the years preceding the euro zone crisis PIMCO was heavily underweight peripheral bonds.

"We own more now than we did back then," said Balls.

Balls prefers Spain and Italy over Portugal and Ireland, two of the bloc's smaller but most indebted countries who last week sold debt in hugely oversubscribed placements, with investors bidding for more than three times the amount offered.

Portugal's 3.25 billion euros sale attracted bids of more than 11 billion from 280 accounts worldwide. Of the amount sold, 88 percent went to non-Portuguese investors. But notably, they included only other Europeans, not U.S. or Asian investors.

Ireland's return to the international bond market drew huge demand for its first post-bailout debt sale, with investors bidding more than 14 billion euros for the 3.75 billion sold. North American investors accounted for 14 percent of buyers.

The largest overseas private sector holder of Irish debt is U.S. fund Franklin Templeton, which built up its stake over the course of 2012 to as much as 10 percent of all outstanding Irish debt.

Other investors are now following that lead, seeing the bonds as less likely than before to swing widely in price.

"As the tail risk has reduced, cross border flows have re-emerged," said Alan Wilde, currency and bond portfolio manager at UK-based Barings Asset Management, which has $58 billion of assets under management.

"We have not participated in auctions but have added modestly to exposures in Ireland, Italy and Spain over the last few months," he said.

JAPAN DIPS TOES BACK IN

Data from Japan's Ministry of Finance show Japanese investors' net buying of Spanish bonds in November was $1.5 billion, the biggest monthly amount since 2006. The net purchase of Italian bonds that month was $709 million, the most since late 2010.

The three-month average of Japanese investment in combined Spanish and Italian debt was a more modest $1.5 billion. But that shows a marked turnaround from the trend in place since early 2011, and is the biggest flow into these bonds since 2009.

Still, Asian investors have been more reluctant than others to buy debt in the European periphery. Only 4 percent of Ireland's bond sale earlier this month was allocated to "other" geographical regions outside Europe and North America.

Kokusai Asset Management, whose Global Sovereign Open fund is the largest mutual fund in Asia, with $127.88 billion of assets under management, is increasing exposure to euro zone bonds but still steering clear of the periphery because of a policy of investing only in debt rated A or higher.

"Whether we'll consider restarting investments in such countries like Spain and others totally depend on whether their ratings climb above the A category," said Masataka Horii, chief fund manager of the fund.

Spain is rated BBB- and Baa3 by S&P and Moody's, respectively, the lowest possible investment grade ratings and three notches from single-A. Portugal is non-investment grade or junk-rated by the main ratings agencies, while Ireland is only one notch below A rating according to Standard & Poor's and Fitch, but still rated junk by Moody's.

U.S. asset manager BlackRock Inc., the largest in the world with over $4 trillion of assets under management, prefers Portuguese bonds over Spanish and Italian because there is more room for yields to converge with benchmark Germany.

"We are invested in both Italy and Spain," said Scott Thiel, deputy chief investment officer and head of global bonds at BlackRock who manages around $100 billion of assets. "But we've trimmed our positions over the last couple of months, it's fair to say."

His portfolio is roughly split evenly between UK, euro zone and global bonds. But the good run euro zone bonds have had of late makes him cautious.

Thiel says Spain is now close to what he and other investors deem "fair value" against the benchmark Germany, a yield differential of 150-200 basis points. The spread narrowed to 180 basis points earlier this month, and is now around 200.