INVESTMENT FOCUS-Investor bond with Ireland hits rocky patch

By John Geddie and Padraic Halpin

LONDON/DUBLIN, Jan 29 (Reuters) - Investors in Irish government bonds face a testing few months, with uncertain national elections and a vote that could see one of its biggest trading partners exit the European Union already leading some to shed their holdings.

Once bailed-out Ireland (Other OTC: IRLD - news) has become the euro zone's fastest growing economy. Its benchmark borrowing costs have plummeted from 15 percent in 2011 to 1 percent, close to levels at which the bloc's second largest economy France can raise debt.

But in recent weeks Irish bonds have underperformed, and major funds including Aberdeen Asset Management (Other OTC: ABDNF - news) , which handles over 290 billion pounds ($415 billion), have exited their overweight positions in Irish debt.

"We have looked at the tight spread to other markets and decided that the uncertainty isn't appropriately priced," Patrick O'Donnell, an investment manager at Aberdeen, said.

The gap (NYSE: GPS - news) between Irish and French 10-year yields hit 10 basis points in early January, its lowest since 2008. On Friday it stood at 31 bps.

The convergence reflected Ireland's growth, budget deficit and borrowing figures, which all looked better than those of France. But for that trend to resume, the country must pass a couple of tests.

The first comes in the election, expected next month, which risks leaving Prime Minister Enda Kenny's coalition short of an overall majority, making Ireland the latest euro zone country to face political deadlock.

Kenny's Fine Gael will almost certainly need the support of junior partner Labour to gain re-election - and the pair remain a few percentage points light.

The largest opposition party, Fianna Fail, has ruled out governing with its rivals, especially Sinn Fein - the one-time political wing of the IRA - with which it could potentially reach a majority.

BANKS AND RATINGS

An inconclusive result could postpone an expected rating upgrade by Moody's into 'A' territory, which would encourage more investors to take up the slack from U.S (Other OTC: UBGXF - news) . fund Franklin Templeton, which held more than 10 percent of Irish debt a couple of years ago but has been divesting its stake.

In a worst-case scenario for investors, any coalition involving the leftist, anti-austerity Sinn Fein would be seen as endangering Ireland's recovery and its commitment to reducing its debt -- still one of the highest in the bloc -- to a sustainable level.

With (Other OTC: WWTH - news) markets having already taken recent inconclusive elections in Portugal and Spain in their stride, due in part to the European Central Bank buying billions of euros of bonds to stimulate the economy, another bout of uncertainty is unlikely alone to shatter investor confidence.

The ECB is set to buy 90 percent of Ireland's gross debt issuance this year, compared with 46 percent in France, according to estimates by ING.

Ireland's Davy Stockbrokers said some overweight positions were being trimmed before the election, but that further jitters could present an opportunity for investors.

"You could see it continuing, if it went five or 10 basis points wider on a spread basis against semi-core or core (debt), I think it'll probably be the buying opportunity of the year in the Irish sovereign," said Eamon Reilly, a trader at Davy.

There are other marginal issues for investors, including how the government can offload its large stakes in Irish banks -- which an inconclusive election result could delay -- and whether increasing disquiet about tax loopholes in the EU could threaten Ireland's attractive low corporate tax offering, which has attracted large inward investment and boosted employment.

SYSTEMIC RISK

The second test, and a systemic risk to the economy, comes with Britain set to a hold a referendum, probably later this year, on membership of the European Union.

A government-commissioned report estimated that any new barriers or tariffs in the event of an UK exit could see trade between the two countries fall by at least 20 percent.

Ireland's government has also outlined concerns over the possible impact on peace in Northern Ireland, part of the United Kingdom and which borders with the Irish Republic and is recovering from three decades of bloody, sectarian violence.

"The serious problem - if you have a Brexit, we (Ireland) would be the clear losers of the euro countries," Alan McQuaid, chief economist at Merrion Stockbrokers said.

($1 = 0.7001 pounds) (editing by John Stonestreet)