* Peripheral sovereign bond sales swamped with orders
* Corporates, financials tracking govvies tighter
* Headline risk and supply dynamics could throw rally off course
By John Geddie
LONDON, Jan 25 (IFR) - Voracious appetite for peripheral European bonds in recent weeks indicates investors are fearful they could miss out on the biggest convergence trade since the single currency was introduced.
Ireland, Portugal, Spain and Italy have all broken back into syndicated bond markets this year, to be met with order books that in some cases have been nearly five-times subscribed.
Yields on 10-year Italy are the lowest since late 2010, Spain's are at 12-months lows, and those of Ireland and Portugal have returned to pre-bailout levels. Strategists now believe the tightening bias has only just got started.
"This is going to play out over the next few months, and by the middle of the year we will see significantly tighter spreads," said Peter Schaffrik, head of European rates strategy at RBC.
"We have already seen this at the front end of the curve, where Italy two-year bonds have dropped below 1.5%, and I'm convinced that 10-year Spanish bonds are going to trade well below the 5% yield we see at the moment."
Comparisons are being drawn with the rally that took place just before the euro was introduced in 1998 - when investors believed all countries would prosper from the project.
In some cases, weaker European economies like Italy saw spreads to Germany track in from well over 300bp in early 1997 to stabilise at around just 30bp after the euro's launch.
Years of excess, fiscal indiscipline and declining productivity have since come to bear on some of the zone's southern states, and 300bp-plus spreads between the core and periphery are a reality again.
But now, investors have another reason to be bullish - the European Central Bank's Outright Monetary Transactions (OMT) programme to buy bonds of struggling peripheral countries.
Away from sovereigns, there are other signs that a widespread convergence is taking hold.
Just 24 hours after Spain printed a EUR7bn 10-year bond on Tuesday, its largest region, Madrid, managed to tap the markets to complete its entire 2013 funding needs in one fell swoop.
"It's a very positive sign that capital is coming back into peripheral government debt - but government debt is the most liquid, so investors can come out as fast as they went in," said Sandra Holdsworth, investment manager for global government bonds at Kames Capital.
"The real success story is Madrid, after the Spanish regions were shut out the market for so much of last year. This debt is fairly illiquid, so seeing investors coming back is a good indication that they are here to stay."
Elsewhere this week, Italian utility Hera became the country's first corporate to issue a 15-year euro deal in 28 months, while Intesa Sanpaolo became the first peripheral bank to take advantage of cheap short-dated funding in 2013 by issuing a new floating-rate note.
Not all investors are quite so confident that this rally can be sustained, however.
"We are beginning to see some cracks in credit that indicates this convergence might be taking a breather," said Sohail Malik, senior portfolio manager for the special situations team at asset manager ECM.
Malik points to peripheral corporates, where aggressively priced deals from Spanish corporates Telefonica, Gas Natural and Iberdrola over the last weeks have all underperformed in secondary markets.
Syndicate officials report that order-book sizes for peripheral corporate and financial bonds are also starting to decline. For sovereigns, this normalisation has not yet set in, with EUR23bn pledged during Spain's bond issue this week. However, with more than EUR100bn still to raise, the concern is that demand will eventually let up.
"Spain's gross issuance will likely reach a record amount in 2013, and despite the recent appetite we have seen for primary issues, we think that demand will be structurally lower as the year progresses and as investors' portfolios fill up," said Nicolas Forest, head of rates and forex at Dexia Asset Management.
At a macro level, there are a plethora of potential headline risks that threaten to throw this convergence off course.
Elections in Cyprus and Italy could bring in regimes opposed to the eurozone austerity measures, and fragile Spain could see its rating junked, with the resulting loss of swathes of investors.
Perhaps most alarmingly, the seemingly robust firewall on which this trade hangs could prove paper-thin.
"The actual execution of the OMT has major potential to disappoint," said Malik.
"As it is trial by committee, and likely to be very conditional in nature, it may not prove to be the impenetrable tail-risk hedge that the market assumes it is." (Reporting by John Geddie; editing by Marc Carnegie and Alex Chambers)