July 20, 2017 / 7:49 AM / a year ago

Southern European bonds feel the heat as ECB balancing act looms

* Italian, Spanish and Portuguese bonds underperform ahead of ECB

* Analysts expect Draghi caution, but risks are to hawkish side

* Spain and France to sell government bonds via auctions

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr

By Abhinav Ramnarayan

LONDON, July 20 (Reuters) - Southern European government bonds underperformed better-rated peers ahead of a European Central Bank meeting at which policymakers are expected to stick to their plans regarding the eventual unwinding of their asset-buying programme.

Italian, Portuguese and Spanish government bonds are seen as the biggest beneficiaries of the central bank’s ultra-loose monetary policy stance of the past few years, and some worry that the market is not fully reflecting the increased risk these countries now face as the ECB moves towards tighter policy.

The gap between their borrowing costs and that of Germany - the bloc’s benchmark - has actually been at the tightest level in months in recent days.

“We have seen very little impact on peripheral spreads since Sintra but this could change very rapidly in a short period of time if the messaging is a bit too hawkish today,” said DZ Bank strategist Daniel Lenz.

He was referring to a recent speech by ECB chief Mario Draghi at Sintra, Portugal, which triggered speculation that the ECB would announce tapering of its bond-buying programme sooner rather than later - potentially as early as September.

“A new discussion on how Italy will cope with the high yield environment when tapering begins will start up, and this is something ECB needs to avoid by all means,” he said.

Any increase in borrowing costs for Italy is seen as problematic because of its high debt levels: it had one of the highest debt-to-GDP ratios in Europe at 132.6 percent at the end of 2016, according to Eurostat.

The Portuguese equivalent figure was 130.4 percent and Spain’s was 99.4 percent.

Italian, Portuguese and Spanish 10-year borrowing costs rose 2-3 basis points on Thursday, underperforming better-rated peers.

The yield on Germany’s 10-year government bond , meanwhile, was up 1 bp at 0.55 percent.

Earlier this week, the gap between Italian and German 10-year government bond yields was close to its lowest level all year at 164 basis points, while the Spain-German 10-year bond yield spread dropped below 100 percent for the first time since September 2016.

Most analysts expect the ECB to play something of a balancing act, keeping the course towards tightening steady while trying to avoid triggering serious market volatility.

But most of the risks are tilted towards a tightening stance.

“It makes little sense for the ECB to spin overly dovish today only to announce a taper in September or October,” Citi analysts said in a note.

That implies a bearish response from bond markets, they said.

Also on Thursday, Greece’s government bond yields rose after IFR reported that the country has hired six banks to manage a new debt sale.

Spain and France are scheduled to sell bonds via auctions on Thursday, potentially putting further upward pressure on yields as investors sell some of their existing holding to raise money to buy new bonds.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets

Reporting by Abhinav Ramnarayan; Editing by Andrew Heavens

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