Spanish funding seen secure as yields hard to resist
* Foreign investors should help Spain meet 2013 funding
* Battle to beat benchmarks drives buying of Spanish debt
* Grab for yield may be enough to help Madrid dodge bailout
LONDON, Jan 11 (Reuters) - Spain should be able to meet its massive 2013 borrowing needs because yield-hungry foreign investment funds cannot afford to miss out on the juicy interest rates paid out on Spanish bonds.
Some overseas investors, though well aware of Spain's heavy debts and weak growth, are starting to buy more of its debt; they are reassured that if things go wrong the European Central Bank will step in - but also know that without Spanish bonds in their portfolio they will struggle to match performance indices.
"If you go underweight Spain you're taking away an asset that yields 5 percent and replacing it with something like Germany, which yields around 1.5 percent," said Iain Stealey, co-manager of the JPMorgan Strategic Bond Fund which has Spanish debt holdings slightly higher than their investment benchmark.
"Very quickly that effect starts to build up ... and if you're not happy owning Spanish and Italian debt it's very hard to find that yield to make the difference back up if you're a dedicated government bond fund."
Since ECB President Mario Draghi promised to "do whatever it takes to preserve the euro", Spain has clawed its way back from the brink of losing the ability to borrow from the public. The 10-year government bond yield that peaked at 7.8 percent in July now stands at 4.9 percent. In just the first eight trading days of 2013, the yield has fallen 37 basis points.
Nevertheless, with local banks already stretched, the support of foreigners is crucial if Spain is to keep its costs under control through a tough year in which its long-term funding needs will grow by 7.6 percent to 121 billion euros.
The ECB has promised that if Spain asks for a bailout programme it will buy bonds with maturities up to three years to keep borrowing costs in check, but Madrid has so far been keen to avoid the political ignominy of asking for outside help.
Even so, the ECB's promise alone has been enough convince international fund managers that, in an environment where investment returns on less risky assets have been squeezed thin, the high yields on Spanish debt are too good to pass up.
For those striving to beat the performance of indices, most of which still include Spanish government debt, the ECB's promise to step in has made the worst-case scenario of a Spanish bailout less likely to happen and also a less daunting prospect.
Five months ago, foreign holdings of Spanish bonds had sunk to their lowest since the launch of the euro at 33.86 percent of the total. November's treasury data shows that proportion had rebounded to 35.44 percent. Analysts see the trend continuing.
The inflow of foreign cash comes even as fund managers - including some of those who are investing more than required to simply track index benchmarks - are able to reel off a laundry list of potential problems in the euro zone.
Draghi said this week there were no grounds for exuberance yet, while bond strategists say the demand for Spanish bonds did not signal an end to the single currency's problems.
"Fundamentally I would not support a trade into Spain, but the liquidity-related momentum is very strong and its hard to fight it at the moment," said Richard McGuire, strategist at Rabobank in London.
"The Spanish clients that we speak to have considerable sympathy with our view - they also themselves believe Spain will come under pressure. But they are long Spanish debt."
Ultimately, some believe the buying generated by a need to put cash to work in higher-yielding investments may mean that Madrid can avoid a bailout and buy the time it needs to turn around its economy without ever activating the ECB's support.
BlackRock, the world's largest asset manager, started increasing exposure to Spanish bonds in the third quarter of last year after Draghi detailed his outright monetary transaction (OMT) bond-buying scheme.
They point to rising cash reserves at the Spanish treasury and say a continuation of the current positive environment could support a strategy of heavier fundraising in the first half of the year to ease the burden later on in 2013.
Scott Thiel, head of European and global bonds at BlackRock, whose team manages $100 billion in fixed income assets, said: "I would suggest they have a good chance now of moving to the end of 2013 without the OMT programme."
(Additional reporting by Emelia Sithole-Matarise and Ana Nicolaci da Costa; Editing by Alastair Macdonald)