MIDEAST DEBT-Buyers nibble at Egypt's international bonds
* Hedge funds, some banks showing interest in Egypt debt
* High-risk bet on successful transition to elections
* Transition could mean further yield fall of at least 200 bps
* Little motive for Egypt to default despite reserve pressures
* Egypt bonds look attractively priced versus Lebanon
DUBAI, July 11 (Reuters) - Some foreign buyers are returning cautiously to Egypt's international bonds, betting the country may succeed in stabilising its economy and engineering a tricky transition back to civilian rule in coming months.
Yields on the bonds have plunged by more than 2 percentage points over the past two weeks. Flows of money have not been large; in many cases, prices are being quoted higher without much actual trading.
Huge uncertainties remain over Egypt's ability to form a stable interim government that would govern until elections, the risk that street violence could develop into a campaign of industrial unrest and militant attacks, and prospects for fiscal reforms to curb the state's soaring budget deficit.
But this week's naming of an interim prime minister acceptable to many Islamists, and pledges of $12 billion in financial aid to Egypt from wealthy Gulf governments, have at least raised the chances of overcoming these obstacles.
And if Egypt does stabilise, the steep drop in its debt prices during the first half of this year means there is plenty of room for them to snap back further. So for some investors, a high-risk bet makes sense.
"Currently we can finally say the market is back...Cautious buying, but there is buying interest at the moment," said Khalil El Bawab, managing director for asset management at investment bank EFG Hermes in Cairo. "Yes, asset managers are willing to increase exposure now."
The yield on Egypt's $1 billion sovereign bond maturing in 2020 soared to a peak of 11.07 percent on June 27 from 5.84 percent at the end of last year, as political tensions worsened and the economy ran deeper into trouble during the last months of president Mohamed Mursi.
The bond began recovering well before Mursi was ousted last week, as it became clear that the army was likely to intervene to remove him - suggesting the market viewed the performance of his government as more of a threat than the tumult created by a military coup.
"The risks attached to Egyptian currency, fixed income and equities are actually lower than 10 days ago because, from an investor's perspective, anything is better than the prior stalemate between the Muslim Brotherhood and old-regime loyalists," said Hasnain Malik, who heads economic research firm Frontier Alpha in Dubai.
Trading in Egyptian bonds is being limited by several factors. Much of the debt is believed to be owned by Egyptian banks who aim to hold it for the long term, viewing it as a hedge against depreciation of the Egyptian pound ; they have been unwilling to sell.
Also, European banks which might have bought the bonds a few years ago are now reluctant to take on fresh risk because the euro zone debt crisis has weakened their balance sheets.
But a trader in London said he had detected some buying by foreign banks, while hedge funds, scenting an opportunity for quick profits, had been bidding up the bonds.
The yield on the 2020 bond has now dropped to 8.64 percent. History suggests that if Egypt's economy and politics do stabilise, the yield may fall much further; it is still more than 300 basis points above its levels late last year, before the political and economic outlook darkened.
Since last year, yields on emerging market bonds have risen around the world, often by more than 100 bps, because of climbing U.S. Treasury yields. But even including this factor, Egyptian yields could still have at least 200 bps to fall.
Last week, when the Egyptian 2020 bond yield was around 10 percent, frontier markets-focused investment bank Exotix switched to a buy recommendation on Egypt's 2020 and 2040 international bonds.
"If and when an Egyptian government demonstrates it is capable of delivering economic adjustment and structural reforms, we see ratings increasing and yields declining rapidly. We think there is 400-500 bps upside in such a scenario," Exotix economist Gabriel Sterne wrote in a report.
The risk that a peaceful transition to elections could be derailed by violence and inter-party squabbling is the main factor deterring many foreign investors in Egypt.
Fitch Ratings cited this factor when it cut Egypt's long-term foreign and local currency issuer default ratings last week to B-minus from B; the outlooks are negative, meaning Fitch could cut again in coming months.
But since the downgrade, the credit default swaps market has shown a reduction in perceived risk in Egypt; five-year CDS are down to 705 bps, their early June level, from last week's peak of 891 bps.
Investors who are optimistic about Egyptian bonds argue the market may not yet have fully digested the positive impact of this week's massive pledges of aid by Saudi Arabia, the United Arab Emirates and Kuwait.
The $12 billion may be enough to prevent balance of payments and state budget crises for the next six months - the period leading up to parliamentary elections, if all goes according to plan. The money may allow the interim government to try to buy social peace by improving fuel and food supplies.
The speed with which the aid was announced suggests the Gulf nations view supporting post-Mursi governments as a geopolitical priority - so if Egypt turns out to need yet more aid, it may be forthcoming.
Other factors argue in favour of Egypt's international bonds. The country's foreign debt is small relative to its economy at under $35 billion at the end of 2012, according to Standard Chartered research, or about 15 percent of gross domestic product.
The maturities of Egypt's two big dollar bonds are far in the future; until then it only has to find money for coupon payments. Fitch estimated its external debt servicing payments were 6 percent of its current account receipts.
So despite pressure on Egypt's foreign reserves, a default may never make sense for Cairo - it would simply freeze the country out of international markets, blocking a sukuk issue which it hopes to make next year, without saving much money.
Meanwhile Egypt is arguably priced attractively in comparison with some other countries hit by political and economic instability, including sectarian divisions and armed conflict among opposing groups.
The yield on Lebanon's $650 million 2019 bond is at 6.24 percent; the sovereign is rated by Fitch just one notch higher than Egypt at B.