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LONDON (Reuters) - In a major turnaround, Portugal has emerged as the year's best performing euro zone bond market outside little-traded Greece, helped by its improving economy and shrinking budget deficit and by the fading threat of a break-up of the bloc.
Benchmark 10-year Portuguese bonds have returned just over 4 percent so far this year, while returns on almost all their euro zone peers are negative, according to Thomson Reuters data. Chart: bit.ly/2p56xdu
Only Greek government debt, the best-performing euro zone bond investment last year but an illiquid market held by few investors, has provided a higher return this year.
For Portugal, the outperformance marks a departure from the southern European borrowers with which it usually moves.
It is also a sea-change from late 2016, when Portuguese debt was battered by worries about a ratings downgrade that could have triggered the country's expulsion from the European Central Bank's bond-buying stimulus scheme.
"I have been surprised about how well Portuguese bonds have performed this year," said Patrick O'Donnell, an investment manager at Aberdeen Asset Management.
Portugal and Italy ended last year with the biggest annual rise in their borrowing costs since the 2011 euro debt crisis - when Portugal was bailed out by the European Union and the International Monetary Fund.
But this year Portuguese bonds have broken ranks. Ten-year yields are down 30 basis points so far in 2017, while Italian IT10YT=TWEB and Spanish peers ES10YT=TWEB are up 45 bps and 22 bps respectively.
A number of factors lie behind that outperformance.
First, the Portuguese economy is improving and the budget deficit shrinking.
Portugal's minority Socialist government has succeeded in lowering the deficit, which fell last year to 2.1 percent of economic output - below a target agreed with Brussels - from 4.4 percent in 2015.
The European Commission has expressed optimism that Portugal can soon exit an EU excessive deficit procedure imposed after it breached the bloc's budget rules.
Analysts say the sale of Novo Banco, carved out of collapsed Banco Espirito Santo in 2014, should help lower the deficit further.
"There have been some positive signs of improving economic conditions, most notably the lowest budget deficit in more than 40 years," said ABN AMRO senior fixed income strategist Kim Liu.
"This could provide hope that the country will be able to leave the so-called excessive deficit procedure by the EU later this year. Also, brighter prospects could lead to an improved rating from the credit rating agencies."
Ratings agency DBRS said last month that Portugal faces "significant challenges" such as high levels of public debt, but notably it confirmed Portugal's BBB rating and stable outlook.
The investment grade rating is the last Portugal holds with a major agency and without it, the country would be ejected from the ECB's bond-buying scheme that has helped anchor borrowing costs.
Concerns about a DBRS downgrade rattled investors last year but last month's review barely registered.
Easing euro zone political risks after the first round of France's presidential election on April 23 have also helped.
Centrist Emmanuel Macron won that vote and is expected to beat rival anti-euro Marine Le Pen in Sunday's run-off vote.
That has reduced concern about a breakup of the euro, boosting lower-rated peripheral markets viewed as most vulnerable to any such fracturing.
"Portugal has done very well recently and it has been a combination of two factors. It was the relief rally after the French first round election result and the fact it offers a pretty decent yield compared to anywhere else in Europe," said Iain Stealey, a portfolio manager at JPMorgan Asset Management who holds Portuguese debt.
"It could well be the best performing bond this year."
Portugal's 10-year yield hit its lowest almost six months on Thursday at 3.45 percent, while the gap with top-rated German yields is 309 bps DE10YT=TWEB -- around its tightest since November.
That is wider than levels around 280 bps seen in August, but tighter than highs around 390 bps hit early this year as investors fretted over the French election.
"Where Portuguese yields go from here will be driven around political risks in Europe and ECB tapering," said Richard Casey, head of government bonds at Pioneer Investments, citing Italian political uncertainty as one factor that could come into play.
Analysts add, though, that most holders of Portuguese debt tend to be long-term investors, who are likely to ride out any turbulence unless there is a big negative shock.
"What would change that is if there were to be a large negative news story but right now what you have is a group of happy longs enjoying the carry," said Padhraic Garvey, head of investment grade bond strategy at ING.
Additional reporting by John Geddie in LONDON and Axel Bugge in LISBON; Editing by Hugh Lawson