Falling Yields

Last year's rally, led by a 47 percent return in Greek bonds, rewarded investors from BlackRock Inc. to Franklin Templeton Investors who took a chance on the region's financial assets. Sovereign debt yields in the euro area fell to 2.55 percent on average this week, lower even than before the global financial crisis, Bank of America Merrill Lynch indexes show.

That's a reversal from late 2011, when borrowing costs soared to almost 10 percent as governments sought international bailouts because they lost access to debt markets. The crisis had worldwide repercussions, with MF Global Holdings Ltd., the New York firm led by Jon Corzine, collapsing when the extent of its bets on European debt became known.

Investor appetite for European government bonds is returning as the region's most-indebted peripheral economies show signs of recovery. Ireland, which had its fastest growth since 2011 in the third quarter, raised 3.75 billion euros ($5.1 billion) from a 10-year bond sale this week as it came back to financial markets after exiting its bailout program.

Yields on Ireland's benchmark 10-year bonds fell as low as 3.25 percent on Jan. 7, the least since January 2006. The extra yield investors receive for holding the securities instead of benchmark German bunds narrowed to 1.35 percentage points from a high of more than 11.5 percentage points on July 2011.

Portugal is now trying to regain full access to debt markets, with the end of its own 78 billion-euro rescue program from the European Union and International Monetary Fund approaching in June. The nation will sell additional 4.75 percent securities maturing in June 2019 priced to yield 330 basis points more than the mid-swap rate, said a person familiar with the arrangement, who asked not to be identified because they're not authorized to speak about it. That's down from initial price talk of about 340 basis points.

The rate on 4.45 percent Portuguese securities due in June 2018 was at 3.99 percent at 12:49 p.m. London time today, after dropping to 3.91 percent yesterday, the lowest for a benchmark five-year note since 2010.

Sluggish Growth

Spain auctioned five-year notes today to yield 2.382 percent, the lowest on record. The nation's two-year note yields fell below 1 percent for the first time on record in secondary-market trading today.

“We've seen a meaningful tightening in the periphery, and it feels as though that trade still has further to run,” said Mark Dowding, a money manager at London-based BlueBay Asset Management LLP, which oversees $56 billion including Portuguese, Spanish, and Italian bonds. “Generally we are playing the periphery from the long-side.” A long position is a bet an asset price will rise.

Europe isn't in the clear yet. The Eurozone's economy will probably grow 1 percent this year, compared with 2.6 percent for the U.S., according to surveys of analysts by Bloomberg News. The jobless rate has climbed to about 12 percent from 7.3 percent in 2008.

“In the last 24 months there has been a progressive reduction in the perception of risk among investors, and we are gradually moving from fear to greed,” said Jacopo Ceccatelli, a London-based partner who manages 2.2 billion euros at financial advisory and asset management firm JCI Capital. “The reduction in the risk perception, and this sort of market euphoria, is leading to a re-rating of sectors and countries most penalized during the sovereign debt crisis.”

The euro, now the currency for 18 nations, rose against all but one of its 16 major counterparts last year as the region's economy emerged from its longest recession on record. It rose 0.3 percent to $1.3613 today, after touching a two-year high of $1.3893 on Dec. 27.

As investor confidence builds, corporate credit risk in the euro region is falling. The Markit iTraxx Europe index of credit-default swaps dropped this week to the lowest since January 2010, while the Markit iTraxx Crossover Index of swaps on high-yield companies declined to the lowest since 2007.

Borrowing Costs

In the bond market, banks are paying less to borrow than industrial companies, with average yields about 4.5 basis points lower than the broader market. That's down from a premium of as much as 70 basis points in November 2011, Bloomberg data show.

The average yield investors demand to hold bonds from financial companies in Spain and other nations from Europe's periphery dropped nine basis points in the past week to a record 2.62 percent, based on Bank of America Merrill Lynch indexes.

“We've seen increased interest in Europe out of the U.S. as people play the recovery story in Europe, and the European periphery in particular,” said Michael Hampden-Turner, an analyst at Citigroup Inc. in London. “Everybody's pretty long, and risk appetite remains strong.”

Europe's lenders are among those benefiting from the rally in sovereign bonds, through their ownership of the securities. Banks in the Stoxx 600 index jumped 2.9 percent on Jan. 7, the most since July, as Ireland returned to the market.

Spanish and Portuguese banks have posted some of the largest increases among European shares this year. Banco Popular Espanol SA rallied 23 percent through yesterday, the most in the Stoxx 600, and Lisbon's Banco Espirito Santo SA jumped 16 percent. Bank of Ireland Plc climbed 15 percent. Among the 10 biggest winners in the Stoxx 600, five were banks, data compiled by Bloomberg show.

Italian banks, which bought government bonds with three-year loans they obtained from the ECB in 2011 and 2012, are the biggest holders of the country's sovereign debt.

Banca Monte dei Paschi di Siena SpA, Italy's biggest holder of Italian bonds relative to its tangible equity, climbed 6.3 percent this year. The Italian bailed-out bank holds 26 billion euros in government bonds, more than three times its tangible capital. UniCredit SpA has jumped 10 percent.

“There's clearly a recovery trade going on,” said Robert Smalley, Global Financials Analyst and head of the credit desk analyst group at UBS AG in New York. “European banks have been operating a self-help policy in preparation for the asset quality review.”

The availability of funding is giving companies with excessive debt loads more time to restructure. Leveraged loan issuance in Europe surged 44 percent last year, with companies borrowing 56 billion euros of the debt, the most since 2007, according to data compiled by Bloomberg.

Billionaires Bill Gates and George Soros have bought stakes in Fomento de Construcciones y Contratas SA, the money-losing Spanish builder that said in November it has about 6 billion euros of debt. The company said yesterday that 95 percent of its lenders agreed to extend its loans for two months as it works to refinance the debt.

The rally's roots can be traced to July 26, 2012, when Draghi pledged to do “whatever it takes” to protect the region from the unfolding debt crisis. The ECB went on to cut its benchmark interest rate to a record 0.25 percent in November to support the recovery. Policy makers held it at that level today, matching the forecasts of all 51 analysts surveyed by Bloomberg.

Greek Profit

Buying Greek bonds the day of Draghi's comments would have earned investors a 370 percent return, based on the Bloomberg Greece Sovereign Bond Index. Ireland's earned 27 percent and Portugal's 42 percent, while U.S. Treasuries lost 3.9 percent.

BlackRock, the world's biggest money manager, is betting on more gains. The firm said last month it supported peripheral bonds with positions in Portugal, Slovenia, Ireland, and Italy. Franklin Templeton is one of the biggest holders of Irish debt, according to data compiled by Bloomberg.

Buoyed by the recovery in debt markets and with his government predicting Greece will return to growth this year for the first time since 2007, Greek Finance Minister Yannis Stournaras said yesterday the nation may sell five-year notes in the second half of the year.

The step would mark Greece's return to bond markets since being shut out in early 2010 following alarm about the size of its budget deficit. Yields on the nation's 10-year debt fell as low as 7.63 percent yesterday, the least since May 2010, and down from a peak of more than 44 percent in March 2012.

“People are generally upbeat and are looking toward further spread tightening,” said AllianceBernstein's Loughney. “Fundamentally there are still significant issues but it looks as though the ECB's friendly stance will continue for the foreseeable future.”

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