Europe's financial markets are picking up where they left off atthe end of 2013, extending a rally in bonds and stocks that'smaking the region's sovereign debt crisis little more than a fadingmemory.

Ireland sold bonds this week, returning to financial marketsafter completing a three-year bailout program. Portugal—another aidrecipient—is holding a sale today. Banks in Spain and otherperiphery countries have never been able to borrow as cheaply asthey can now. The Stoxx Europe 600 Index of stocks closed at itshighest level since May 2008 yesterday, and the euro is about itsstrongest since 2011 against the dollar.

Such is the confidence in Europe that Greece, which sparkedEurope's sovereign-debt woes in 2009 and required two bailouts,said yesterday that it may sell bonds this year. That would mark aturnaround in the region after nations were shut out of debtmarkets, triggering the collapse of governments and causingunemployment to top 12 percent. It took a pledge from EuropeanCentral Bank (ECB) President Mario Draghi in July 2012 to “dowhatever it takes” to keep the currency bloc from breakingapart.

“The market is feeling very confident,” said Daniel Loughney, afixed-income money manager in London at AllianceBernstein HoldingLP, which oversees $446 billion. “They know the ECB will want tosupport them. It's in everyone's interest not to upset the applecart.”

Falling Yields

Last year's rally, led by a 47 percent return in Greek bonds,rewarded investors from BlackRock Inc. to Franklin TempletonInvestors who took a chance on the region's financial assets.Sovereign debt yields in the euro area fell to 2.55 percent onaverage this week, lower even than before the global financialcrisis, Bank of America Merrill Lynch indexes show.

That's a reversal from late 2011, when borrowing costs soared toalmost 10 percent as governments sought international bailoutsbecause they lost access to debt markets. The crisis had worldwiderepercussions, with MF Global Holdings Ltd., the New York firm ledby Jon Corzine, collapsing when the extent of its bets on Europeandebt became known.

Investor appetite for European government bonds is returning asthe region's most-indebted peripheral economies show signs ofrecovery. Ireland, which had its fastest growth since 2011 in thethird quarter, raised 3.75 billion euros ($5.1 billion) from a10-year bond sale this week as it came back to financial marketsafter exiting its bailout program.

Yields on Ireland's benchmark 10-year bonds fell as low as 3.25percent on Jan. 7, the least since January 2006. The extra yieldinvestors receive for holding the securities instead of benchmarkGerman bunds narrowed to 1.35 percentage points from a high of morethan 11.5 percentage points on July 2011.

Portugal is now trying to regain full access to debt markets,with the end of its own 78 billion-euro rescue program from theEuropean Union and International Monetary Fund approaching in June.The nation will sell additional 4.75 percent securities maturing inJune 2019 priced to yield 330 basis points more than the mid-swaprate, said a person familiar with the arrangement, who asked not tobe identified because they're not authorized to speak about it.That's down from initial price talk of about 340 basis points.

The rate on 4.45 percent Portuguese securities due in June 2018was at 3.99 percent at 12:49 p.m. London time today, after droppingto 3.91 percent yesterday, the lowest for a benchmark five-yearnote since 2010.

Sluggish Growth

Spain auctioned five-year notes today to yield 2.382 percent,the lowest on record. The nation's two-year note yields fell below1 percent for the first time on record in secondary-market tradingtoday.

“We've seen a meaningful tightening in the periphery, and itfeels as though that trade still has further to run,” said MarkDowding, a money manager at London-based BlueBay Asset ManagementLLP, which oversees $56 billion including Portuguese, Spanish,and Italian bonds. “Generally we are playing the periphery from thelong-side.” A long position is a bet an asset price will rise.

Europe isn't in the clear yet. The Eurozone's economy willprobably grow 1 percent this year, compared with 2.6 percent forthe U.S., according to surveys of analysts by Bloomberg News. Thejobless rate has climbed to about 12 percent from 7.3 percent in2008.

“In the last 24 months there has been a progressive reduction inthe perception of risk among investors, and we are gradually movingfrom fear to greed,” said Jacopo Ceccatelli, a London-based partnerwho manages 2.2 billion euros at financial advisory and assetmanagement firm JCI Capital. “The reduction in the riskperception, and this sort of market euphoria, is leading to are-rating of sectors and countries most penalized during thesovereign debt crisis.”

The euro, now the currency for 18 nations, rose against all butone of its 16 major counterparts last year as the region's economyemerged from its longest recession on record. It rose 0.3 percentto $1.3613 today, after touching a two-year high of $1.3893 on Dec.27.

As investor confidence builds, corporate credit risk in the euroregion is falling. The Markit iTraxx Europe index of credit-defaultswaps dropped this week to the lowest since January 2010, while theMarkit iTraxx Crossover Index of swaps on high-yield companiesdeclined to the lowest since 2007.

Borrowing Costs

In the bond market, banks are paying less to borrow thanindustrial companies, with average yields about 4.5 basis pointslower than the broader market. That's down from a premium of asmuch as 70 basis points in November 2011, Bloomberg data show.

The average yield investors demand to hold bonds from financialcompanies in Spain and other nations from Europe's peripherydropped nine basis points in the past week to a record 2.62percent, based on Bank of America Merrill Lynch indexes.

“We've seen increased interest in Europe out of the U.S. aspeople play the recovery story in Europe, and the Europeanperiphery in particular,” said Michael Hampden-Turner, an analystat Citigroup Inc. in London. “Everybody's pretty long, and riskappetite remains strong.”

Europe's lenders are among those benefiting from the rally insovereign bonds, through their ownership of the securities. Banksin the Stoxx 600 index jumped 2.9 percent on Jan. 7, the most sinceJuly, as Ireland returned to the market.

Spanish and Portuguese banks have posted some of the largestincreases among European shares this year. Banco Popular Espanol SArallied 23 percent through yesterday, the most in the Stoxx 600,and Lisbon's Banco Espirito Santo SA jumped 16 percent. Bank ofIreland Plc climbed 15 percent. Among the 10 biggest winners in theStoxx 600, five were banks, data compiled by Bloomberg show.

Italian banks, which bought government bonds with three-yearloans they obtained from the ECB in 2011 and 2012, are the biggestholders of the country's sovereign debt.

Banca Monte dei Paschi di Siena SpA, Italy's biggest holder ofItalian bonds relative to its tangible equity, climbed 6.3 percentthis year. The Italian bailed-out bank holds 26 billion euros ingovernment bonds, more than three times its tangible capital.UniCredit SpA has jumped 10 percent.

“There's clearly a recovery trade going on,” said RobertSmalley, Global Financials Analyst and head of the credit deskanalyst group at UBS AG in New York. “European banks have beenoperating a self-help policy in preparation for the asset qualityreview.”

The availability of funding is giving companies with excessivedebt loads more time to restructure. Leveraged loan issuance inEurope surged 44 percent last year, with companies borrowing 56billion euros of the debt, the most since 2007, according to datacompiled by Bloomberg.

Billionaires Bill Gates and George Soros have bought stakes inFomento de Construcciones y Contratas SA, the money-losing Spanishbuilder that said in November it has about 6 billion euros of debt.The company said yesterday that 95 percent of its lenders agreed toextend its loans for two months as it works to refinance thedebt.

The rally's roots can be traced to July 26, 2012, when Draghipledged to do “whatever it takes” to protect the region from theunfolding debt crisis. The ECB went on to cut its benchmarkinterest rate to a record 0.25 percent in November to support therecovery. Policy makers held it at that level today, matching theforecasts of all 51 analysts surveyed by Bloomberg.

Greek Profit

Buying Greek bonds the day of Draghi's comments would haveearned investors a 370 percent return, based on the BloombergGreece Sovereign Bond Index. Ireland's earned 27 percent andPortugal's 42 percent, while U.S. Treasuries lost 3.9 percent.

BlackRock, the world's biggest money manager, is betting on moregains. The firm said last month it supported peripheral bonds withpositions in Portugal, Slovenia, Ireland, and Italy. FranklinTempleton is one of the biggest holders of Irish debt, according todata compiled by Bloomberg.

Buoyed by the recovery in debt markets and with his governmentpredicting Greece will return to growth this year for the firsttime since 2007, Greek Finance Minister Yannis Stournaras saidyesterday the nation may sell five-year notes in the second half ofthe year.

The step would mark Greece's return to bond markets since beingshut out in early 2010 following alarm about the size of its budgetdeficit. Yields on the nation's 10-year debt fell as low as 7.63percent yesterday, the least since May 2010, and down from a peakof more than 44 percent in March 2012.

“People are generally upbeat and are looking toward furtherspread tightening,” said AllianceBernstein's Loughney.“Fundamentally there are still significant issues but it looks asthough the ECB's friendly stance will continue for the foreseeablefuture.”

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