By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - After going gung-ho on the euro zone's weakest economies in the second half of last year, U.S. fund managers are paring back their bond holdings in the region, sensing they've seen the best for now.
Total returns on government debt in so-called "peripheral" countries in Europe -- Greece, Spain, Portugal, Italy and Ireland -- have descended back to earth in the new year after hitting the stratosphere in 2012, and that's making some U.S. investors nervous.
For instance, Standish Asset Management in Boston, has already cut its positions in the group. Others, such as Oppenheimer Funds, are holding on, but are ready to act quickly if one of the countries fails to meet targets under its austerity program.
"It is becoming more difficult to find hidden gems in the periphery," said Raman Srivastava, deputy chief investment officer and head of global fixed income at Standish. "There won't be a Portugal where returns totaled nearly 60 percent last year. Those were picked over."
U.S. investors became major buyers of the group's sovereign debt in the second half of 2012, encouraged by the promise of support from the European Central Bank. The ECB has committed to buying bonds with maturities of one and three years from euro zone countries seeking financial assistance.
Standish, which manages fixed-income assets of about $170 billion, was one of the early U.S. bulls on the European periphery, buying up its bonds early last year in auctions and the secondary market.
U.S. investors accounted for 3 percent of Spanish bonds bought in last month's auctions, 6 percent of Italian bonds, 9 percent of Irish bonds, and 33 percent of Portuguese bonds, JP Morgan data show.
But these investments are fraught with risk.
Some of these countries remain fragile despite financial backing from European institutions. Any setback, global or local, could negate the extensive efforts made to prop up their struggling economies, which could mean huge losses for investors holding their debt.
"The periphery remains vulnerable to external shocks. While it's improving, it's improving very slowly," said Hemant Baijal, portfolio manager of Oppenheimer's $12.9 billion global bond fund.
Baijal said Oppenheimer holds a "somewhat underweight" position after going overweight in the past, adding that the global bond fund still has exposure in Spain, Italy, Portugal, and Ireland. He declined to give specifics.
YIELDS STARTING TO FLARE AGAIN
After recent declines, sovereign bond yields -- which move in the opposite direction to prices -- have also started to inch up again, suggesting investors have become a bit more fearful, demanding an additional premium for holding their bonds. Italy's February 24 elections and allegations of a corruption scandal in Spain were cited as the main triggers for the latest spike.
Peter Wilson, managing director at First International Advisors in London said the rise in those countries' yields is further evidence that it is no longer a one-way bet on those countries.
Italian yields briefly spiked to 4.72 percent on Friday, a roughly seven-week peak, after plumbing two-year lows of 4.12 percent in mid-January. Spanish yields touched the 5.55 percent level this week after sinking to 10-month troughs of 5.04 percent also in mid-January.
Italy's bonds have delivered a dollar-denominated total return of 2.1 percent so far this year, while Spanish sovereign debt has a total return of 2.3 percent in dollar terms, but returns on both are negative since the start of February. That compares with gains of 20 percent in the final six months of 2012, fixed-income data from Bank of America Merrill Lynch shows.
Portugal, one of the periphery's investment darlings in 2012, has a total return of just 1.8 percent this year down from almost 60 percent last year.
BOOST FROM STRONG EURO
That said, even with the plunge in returns, U.S. funds holding European debt are still benefiting from a strong euro against the dollar. Over the last six months, the euro has gained more than 6 percent, boosting the total return for a U.S. investor when currency translation is factored into the mix.
"Euro zone debt of specific countries can still add value in a U.S. portfolio, performing better than many of the U.S. sectors, including U.S. Treasuries," said Standish's Srivastava. He added that the firm has outperformed its benchmarks this year in part due to correctly positioning funds within the euro zone periphery.
Standish has reduced its overweight position on peripheral bonds, trimming holdings toward the end of last year as yield spreads started compressing. Srivastava declined to provide figures for its bond holdings.
It remains active in the sector, but has become more selective, shifting holdings of its bonds among Italy, Spain, Portugal, Ireland, and Slovenia.
Oppenheimer's Baijal, on the other hand, acknowledged the risks in Spain and Italy and said should the political situation worsen in these countries, Oppenheimer would take action.
"A continuation of negative news that may impact future economic reforms in both countries may result in a more defensive posture, but not necessarily in the periphery," Baijal said.
In the case of First International Advisors, which is owned by Wells Fargo Asset Management, the firm has chosen not to do anything for the time being, but said it is monitoring the situation in Spain and Italy closely. These two countries are part of Wells Fargo's $1.9 billion global bond fund, which First International helps manage.
But if U.S. funds need to remain in the periphery, Kathy Jones, Charles Schwab's fixed income strategist recommends hedging bets by "staying fairly short duration -- two to five years -- or within three-year window that the ECB promised."
(Editing by Dan Burns and Leslie Gevirtz)