South Africa's bonds still a favorite despite GDP setback

* S.Africa's political stability to attract investors

* "Compelling" yields offset GDP contraction -analyst

* C.bank independence, low inflation shields local assets

JOHANNESBURG, June 7 (Reuters) - South African bonds are set to outshine some of their emerging market peers even after the economy contracted in the first quarter, as investors bet the country's new political leadership will adopt more business-friendly policies, analysts said.

Local assets have rallied since Cyril Ramaphosa took over as leader of ruling African National Congress in December and as South African president in February. The trade union leader-turned-businessman is expected to bring more political stability than his scandal-plagued predecessor Jacob Zuma.

With policy changes by the new administration seen gaining speed over the course of this year, yield-hungry investors put off by stalled reforms in other emerging markets may find comfort in the high returns offered by South Africa's bonds.

Emerging debt sold off heavily in May as U.S. Treasury bond yields rose sharply but flows out of South Africa were mild in comparison, with demand from institutional investors trumping any short-term panic.

Chief Africa economist at Standard Chartered Razia Khan said South Africa's disappointing first quarter growth figures, which showed the largest quarterly contraction in nearly decade, were unlikely to deter investors.

"South African real interest rates relative to the rest of the world still look very compelling," said Khan in Johannesburg on Wednesday. "We are already seeing a lot of analysis saying if you see emerging markets as providing a buying opportunity, look to South Africa first. The positivity will come back."

Gabriele Foa and David Hauner, strategists at Bank of America Merrill Lynch, said recent improvements in South Africa's budget, high real interest rates and a relatively steep curve made local bonds even more attractive.

"10 year ZAR bonds yield 8.7 percent, while we forecast inflation at 4.6 percent for 2018. A 4 percent real rate is high compared to what South Africa usually offers and versus emerging market peers too," they said.

ROTATION OF RISK

South Africa's benchmark bond yields slightly more than similarly-rated Indonesia's 7.2 percent and Russias 7.4 percent, but much less than Brazils 12 percent and Turkeys 13.7 percent.

"There is of course a fairly decisive reason for this, being the lack of political instability, which has led to a strong rotation of risk out of other more volatile countries and into our markets," Standard Bank's chief trader Warrick Butler said in a note, also comparing South Africa favorably to Argentina.

The calm is also reflected in one-month implied volatility for the rand, a gauge of expected swings in the currency, which is near its historic average and lower than for many key emerging currencies, such as Turkey's and Indonesia's.

Craig Botham, emerging markets economist at Schroders, which manages over $500 billion worth of assets globally, said the independence of South Africa's central bank and lower inflation, seen averaging 4.9 percent in 2018, would steel local bonds against the recent EM turbulence.

Botham said reforms at state firms -- including sole power utility Eskom, where the government has made executive appointments since Ramaphosa became president -- were sending positive signals to investors.

"It's also a sentiment thing. Reforms around state-owned companies and moves to remove some of government's intervention in the economy are really helping," he said. ($1 = 12.6900 rand) (Editing by James Macharia and Catherine Evans)