* Greek bonds may struggle to rally further
* "Grexit" risks seen low but could resurface at any time
* Thinning volumes viewed as sign of vulnerability
By Marius Zaharia
LONDON, Jan 29 (Reuters) - A powerful rally in Greek government bonds, which has seen prices surge four-fold since June, is running out of steam with investors still nervous the bailed-out country could be at risk of leaving the euro zone.
Expectations - confirmed last week - that Greece would secure further bailout funds and bets further losses will not be imposed on private Greek bond holders have cut the return investors demand to hold 10-year Greek bonds by two thirds from record levels of 30 percent before elections last June.
Fears Greece could leave the euro peaked before the election when, with voters enraged at mainstream parties that had imposed harsh spending cuts, investors thought anti-bailout politicians might come to power.
Those worries have since eased but, for the rally to go much further, investors would effectively be pricing out any exit risk, analysts said. This is seen as premature.
Economists and Greek debt holders say austerity measures imposed by the conservative-led government could lead to further social unrest and destabilise the coalition, whose narrow parliamentary majority has already been cut by defections.
That could open the door to radical leftists, raising the risk of a so-called "Grexit". The implications could be felt beyond Greece, complicating efforts by Italy and Spain, whose bonds are also rallying, to emerge from their own debt problems.
"There is still residual political risk around the coalition amid the further cuts in spending that will be implemented this year and if there was any political turmoil then talk of Grexit would resurface," said Julian Adams, CEO at Adelante Asset Management, who said he made close to 100 percent profit from his position in Greek bonds last year.
Distressed debt brokerage Exotix has designed a pricing model based on three equally-weighted scenarios: euro exit, "staggering along" and economic recovery. That puts what they call the "fair" average price on all Greek bonds at about 40 cents in the euro, versus 46 currently, implying an average yield of about 11 percent versus 9.8 percent.
Current prices reflect an exit probability of 25 percent based on that model and the firm's economist Gabriel Sterne, who recommended investors buy Greek bonds for most of last year, said this was too low and that it was time to sell.
"My view is based primarily on political and social risks. You talk to anyone in Greece and they tell you they feel like living a social experiment," Sterne said, adding risks were skewed towards an even greater increase in the exit probability than the current assumption of his pricing model.
If Greece were to leave the euro, average yields should rise to 24 percent, whereas if Greece were to consolidate its euro zone membership by returning to growth, yields should fall towards 6.8 percent, Sterne said.
The yield on the Greek February 2023 bond was last around 10.5 percent, about half what it was when the bond was launched as part of a restructuring, under which the government swapped old bonds for lower-priced new debt, in March 2012.
In Italy, whose debt, at about 1.3 times the size of the economy is comparable with Greece's 1.5 times but which is not seen at risk of euro exit, equivalent yields are about 4 percent.
An indication that the rally could stall, or even sharply reverse, is that traded volumes are thinning out, analysts say.
Trading peaked just before Greece, in a second attempt to reduce overall debt, bought back some of its bonds at a discount in early December, due to bets the remaining bonds, which account for only a tenth of Greece's 300 billion euro debt pile, will be repaid in full at maturity.
In September, October and November volumes were around 100 million euros per month, according to data from HDAT, the trading platform operated by the Bank of Greece.
But that fell to 40 million euros in December. In January, data for all but the last five sessions showed volumes of 56 billion. Six of the January sessions saw no trades.
Sohail Malik, lead portfolio manager for the ECM Special Situations hedge fund, said he sees about three dealers a day placing bids or offers in the market, down from as many as six before the buyback. Offer sizes have fallen to 10 million euros versus 50 million previously, he said.
"If there is a big holder that had to sell for some reason - a hedge fund that has to meet some redemptions, or other issues - this is a vulnerable market," Malik said. He expects yields to stabilise near-term, saying investors need more information before adding to or unwinding their positions.
If Greece made progress in implementing reforms prescribed in its bailout programme and broader euro zone sentiment stayed positive, yields could fall into single digits, he said.
This is in line with the view of Morgan Stanley, which said in a note average yields on Greek bonds could fall to about 9 percent in the medium-term, assuming progress on the economy and continued support from its lenders.
Malik says that if the governing coalition came under pressure, 10-year yields could rise to as much as 15 percent. Renewed exit worries would affect other euro zone members.
"If the ring is broken there are very negative market effects for the whole euro zone," Malik said.