Hedge funds foiled by Europe's distorted debt market

(Repeats Thursday item with no changes)

* Soaring cost of borrowing bonds in repo market has benefit

* Speculators put off by expense of 'shorting' countries

* Strategists say trend helped stem Greek crisis contagion

By John Geddie

LONDON, Aug 6 (Reuters) - Ultra-easy European Central Bank monetary policy is protecting the debts of some of the bloc's weakest countries from attack by speculative hedge funds.

Through a combination of low rates and bond purchases over the last four months, the ECB has pushed up the value of euro zone debt to the extent that leveraged investors now find it too expensive to borrow the bonds they need to take a 'short' position on a country's debt.

Short-selling is the sale of a borrowed security. Funds tend to borrow bonds via repurchase agreements, or repo, from banks which need cash. They then sell these borrowed bonds on to investors, hoping to replace them more cheaply before their initial transaction expires.

European benchmark repo, or secured lending rates, for three-month terms have fallen 15 basis points since 2012 and are now negative, meaning that funds have to pay a premium to swap cash temporarily for those bonds. In short, bonds are now deemed more valuable than cash.

Repo markets are not used exclusively by hedge funds and are also vital to the smooth running of financial markets as they allow companies to manage their cash balances.

A dysfunctional repo market can therefore have economic consequences but for some of the euro zone's most vulnerable countries it is having an unexpected benefit.

"The chance of a speculative attack or the amplification effect from short sellers is reduced if the repo market is not functioning," said JPMorgan (LSE: JPIU.L - news) analyst Nikolaos Panigirtzoglou.

The last major attack on euro zone bonds was in the summer of 2012, when Greece teetered on the brink of leaving the currency union and fear spread that Spain may need a bailout. Hedge funds smelled blood and started to 'short' the debt of the bloc's weak links.

Borrowing costs in Italy - the euro zone's second biggest debtor - shot above 7 percent, a level where it was seen as at risk of being shut out of financial markets.

Tensions were only soothed by ECB president Mario Draghi's pledge to do "whatever it takes" to save the euro, and by policy measures that culminated in the launch of its bond-buying QE scheme in March.

Distortions in the repo market don't stop investors simply selling their bonds if their perceptions change. But strategists say the barriers to entry for the opportunistic short-seller did help stem any contagion from the latest Greek crisis when Athens' membership of the euro area was once again in question.

Greek 10-year bond yields reached nearly 20 percent during last month's battle with creditors. Italian equivalents barely got above 2 percent.

UPSIDES

There are still ways for investors to short euro zone debt without relying on repo, but these are limited to countries with a large and liquid futures market - in the euro zone, just Germany, France and Italy.

Traders said a sell-off in German bonds in mid-April, partly on hints that inflation was rebounding, was typified by large volumes of activity in these financial derivatives rather than trading in the underlying cash bonds.

For a country like Portugal though, which has no futures market, the typical way to short has been through repo. Now (NYSE: DNOW - news) , investors say, that is not possible.

A repo broker contacted by Reuters said there was no market for Portuguese government general collateral (GC) -- a basket of eligible assets -- even for overnight transactions.

Yields on low-rated Italian and Spanish government GC have turned negative, a trend analysts say is exacerbated by the shortage of the bonds in the market.

"I don't think the ECB was fully aware that QE was going to make repo rates so expensive ... but it has got its upsides," said Mizuho strategist Peter Chatwell. (Editing by Ruth Pitchford)