LONDON (Reuters) - Ripples in parts of the European bond market are signalling that Spain could feel the heat if Greece fails to clinch a debt deal with lenders and exits the currency bloc.
Political risk stemming from the leftwing Syriza party's victory in Greece's Jan. 25 parliamentary election and its continuing standoff with lenders has so far had modest impact on other peripheral euro zone economies.
But Spain, the euro zone's fourth largest economy, is viewed as most vulnerable to future contagion following the meteoric rise of anti-austerity party Podemos ahead of national elections expected in November. Podemos is often compared to Syriza.
Financial markets are again on edge as Greece refuses to accept an extension of its deeply unpopular bailout package that expires in just two weeks. [ID:nL5N0VM2VI]
The European Central Bank's sovereign bond purchase programme has so far limited any contagion affecting debt issued by Spain, Italy and Portugal, which were at the forefront of the euro zone debt crisis in 2012.
However, Spanish bonds have underperformed peripheral peers and German benchmarks since Syriza swept to power.
Spanish 10-year yields have edged up nearly 40 basis points to 1.62 percent from a record low of 1.25 percent hit on Jan. 23. Their premium over German Bunds is at a 2-1/2 month high of 133 bps.
Italian yields have also retreated from their troughs but by just 23 bps to 1.64 percent. Their premium over Spanish yields has narrowed from around 25 bps at the start of 2015.
"Spain has a general election this year and ... investors are building in an election risk premium, a modest one for now,, because you have also got this anti-austerity party like Syriza, Podemos that is gaining in polls," said Mathias van der Jeugt, a strategist at KBC.
"The Greek election showed that such anti-austerity parties could come from effectively nowhere and win."
An opinion poll published on Feb. 8 showed Podemos, which is barely a year old, could win Spain's election with nearly 28 percent of the vote, ahead of the two mainstream parties that have dominated Spanish politics for decades. [ID:nL5N0VI0II]
Like Syriza, Podemos has tapped into widespread anger over corruption in Spanish political and business circles.
Unlike Greece, Spain has a recovering economy and full access to capital markets where its borrowing costs are around record lows. Investors are more concerned that Podemos' rise might push the mainstream parties to renege on reforms that helped haul Spain back from the brink of a bailout in mid-2012.
"One of the reasons we favoured being long Spain versus Italy was that Spain had appetite for reforms while Italy didn't. The tables have turned," said Marco Brancolini at RBS.
"Italy is implementing some reforms though more is needed. With the rise of Podemos all parties in Spain are a lot less willing to embark on reforms. The agenda is completely shifting towards more populist measures."
He said he expected Spanish 10-year yields to trade five bps above Italian equivalents in coming months, adding that Spanish regional elections in May would prove a "wake-up call".
Editing by Gareth Jones