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Why Europe’s bonds keep finding buyers

Most European bond yields are barely keeping their nose above water, but there's one place they're likely to keep finding interested investors: Europe.

"Domestic European investors are still very interested in European fixed income," David Zahn, head of European fixed income at Franklin Templeton, said. "They're actually looking for ways to diversify within Europe."

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On their face, European sovereign bonds don't look like much of a draw for fixed income investors. Across the euro zone, yields on many short- to mid-dated bonds have turned negative in recent months. Germany's two-year Bund yields, for instance, are trading around negative 0.23 percent, with the curve not turning positive until the seven-year Bund. Its benchmark 10-year bond is yielding around 0.25 percent. France's two-year bond is trading around negative 0.13 percent.

How low can they go?

But with the European Central Bank (ECB) starting purchases of sovereign bonds under its new quantitative easing program, already low yields could get even lower; bond prices rise as yields fall.

"Yields in Europe can remain at these low levels or even go lower in the context of the U.S. yields maybe rising," as the U.S. Federal Reserve may begin raising interest rates this year, Zahn said.

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Zahn has been buying peripheral Europe's debt, where yields are higher than in the core countries such as Germany and France. Spain's 10-year bond yield is trading around 1.15 percent and Portugal's is around 1.58 percent. He's also been going for longer duration bonds. The ECB has said it won't buy bonds yielding less than its deposit rate of negative 0.2 percent, and much of Europe's negative-yielding bonds are clustered at the short end.

In general, Europe's bond prices may benefit from scarcity as the ECB tries to buy around 60 billion euros worth a month.

"Some long-term investors will not be looking to sell to the ECB because they have asset-liability matching that they're trying to do," Zahn said. "That reduces the amount of bonds out there for the ECB to buy."

Eye on the periphery

Others also expect the best bets on Europe's bonds will be in the periphery.

International holders of Europe's bonds are likely to be the main source for the ECB's quantitative easing program, Barclays said in a note Monday.

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Sean Gallup | Getty Images

"Euro area-based investors, whether banks or other asset managers, at best, are likely to rebalance their portfolios within the European government bond (EGB) universe (ie, move further down the credit scale and/or move higher along the maturity spectrum)," Barclays said. "The ECB may well have to bid bonds aggressively to procure them from their holders."

It expects the markets with less international ownership will see the biggest impact on pricing.

"International ownership of euro debt is skewed toward less-risky assets" in core Europe, suggesting the ECB buying will have a bigger impact on the prices of Spanish and Italian bonds, it said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1