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Greek yields hit 2014 highs on emerging market vulnerability

* Greek yields hit 2014 high amid emerging market rout

* Spain, Italy insulated by large domestic investor holdings

* Recent Portuguese debt sell-off raises market return worry

By Marius Zaharia

LONDON, Jan 27 (Reuters) - Greece's government bond yields hit their highest this year on Monday with the country seen as the most vulnerable in the euro zone to a spillover from an emerging market sell-off.

Bond yields in Portugal, seen as the other weak link in the region, fell. However, traders said volumes were low and analysts cautioned yields could rise again if the emerging market rout accelerates.

Tighter credit conditions in China and expectations the Federal Reserve will further scale back its monetary stimulus have fuelled a large outflows from developing markets, with currencies in Turkey, Argentina and Russia hitting record lows.

The sell-off hit junk-rated Greek and Portuguese bonds more than their euro zone peers. In stock markets, by contrast, Spanish shares were among the worst hit due to their exposure to Latin America.

Limiting the impact on Spanish bonds, two-thirds of the debt is in the hands of domestic investors, who are less likely to sell when global sentiment towards risky assets sours. By comparison, only about half of Portuguese bonds are owned by locals, making the country more vulnerable to such shifts.

At a sale of 10-year bonds last year, only 14 percent of the bonds were sold to Portuguese investors, debt agency data show. UK and U.S. buyers took larger chunks.

At Spain's 10-year bond sale last week, 39 percent went to domestic investors, according to a primary dealer.

Data on Greece was not immediately available, but traders say many of the bonds are in the hands of foreign hedge funds, many of them based in the United States.

Bailed-out Greece and Portugal have also lured investors with mandates to invest in emerging markets as their yields are close to those in similarly-rated developing economies. As the duo have dropped out of the main euro zone bond indexes due to their low ratings, they count on a significantly different investor base than do other euro zone states.

"Italy and Spain have strong internal demand, while Portugal and Greece rely on investor demand from abroad and a lot of it has come from emerging market fund managers recently ... as they found the yield attractive," ING rate strategist Alessandro Giansanti said.

Greek 10-year yields rose 12 basis points to 8.75 percent, having earlier hit a five-week high of 8.90 percent, according to Reuters data. This followed a 20 bps rise in yields on Friday when the emerging market sell-off was more intense.

Equivalent Portuguese yields fell 7.5 bps to 5.22 percent, but remained over 20 bps above Thursday's close.

Italian and Spanish yields were flat on the day and less than 10 bps higher than on Thursday.

Portuguese bonds' initial reaction to the emerging market tensions triggered worries that Lisbon may need some form of financial assistance when its EU/IMF bailout deal ends later this year, said Gianluca Ziglio, an analyst at Sunrise Brokers.

"The situation shows that whatever happens in the world is also going to affect Portugal's ability to have market access at an acceptable rate," Ziglio said.

Yields on German 10-year Bunds, the euro zone benchmark seen as one of the safest assets in the world, rose 2 bps to 1.675 percent, having fallen 5 bps on Friday.