(Reuters) – Three years ago, when its banks started to go under, a grim joke was doing the rounds in Dublin, “What’s the difference between Ireland and Iceland? One letter and six months.”

Now the comparison is back and this time it’s a positive.

Ireland’s sovereign bonds have been the best performers in Europe over the past six months, with the yield on two-year paper dropping from a high of 24 percent to just over five percent, prompting some investors to ask when Ireland is going to follow Iceland’s June 2011 return to global capital markets.

Ireland’s success in meeting its targets under an EU-IMF bailout without social or political unrest and its export-focused economy has enabled it to dodge the recent euro zone downgrades by S&P and Fitch and distance itself from fellow bailout recipients Greece and Portugal.

S&P and Fitch still rate Irish debt three notches above junk, differing with Moody’s more downbeat assessment. Portugal, in contrast, is rated sub-investment grade by all three agencies. This week its yields rose to 17 percent, prompting speculation that, like Greece, it will need a second bailout.

Ireland’s 10-year yields have recovered to 7 percent from around 14 percent in July. But it isn’t entirely plain sailing. Ireland’s divergence from Greece and Portugal and the comparisons with Iceland, which exited its IMF program last year, only go so far.

A successful 3.5 billion euros debt swap last week was hugely important in cutting Ireland’s borrowing requirement for 2014 but the take-up was dominated by Irish banks looking for collateral for the ECB’s next offer of ultra-cheap three year loans rather than international investors. If it wants to persuade foreign investors to buy medium-term debt, Ireland will have to deal with some major obstacles.

PLAY ON GROWTH

Ireland would be exposed once more if Greece were suddenly to default. And even if worries over Greece ease after March, when 14.5 billion euros of Greek debt fall due, Ireland’s growth prospects need to improve to reassure investors that its debt burden, currently expected to peak at 119 percent of GDP in 2013, won’t get any worse, bankers say.

Of Europe’s weak links – Portugal, Ireland, Italy, Greece and Spain – Ireland is the only one expected to post GDP growth this year. But the outlook has worsened along with global demand. A recent Reuters poll of 22 economists forecast median GDP growth of just 0.3 percent for Ireland this year compared with 0.7 percent in a November survey.

Unlike Iceland, where a slide in the currency helped the economy rebound, Ireland’s euro membership rules out a devaluation.

But with one of the most trade dependent economies in the world — gross exports account for over 100 percent of GDP — Ireland’s fortunes would turn around quickly if the global outlook improves. An IMF study showed a 1 percent change in annual U.S. GDP caused annual Irish GDP to change by 1.8 percent while a 1 percent change in euro area GDP triggered a 1.5 percent change.

“Ireland is a leveraged play on growth,” said Steven O’Hanlon, chief investment officer of fixed income at ACPI Investment Managers.

“If global growth does not falter, Ireland has the potential to outperform other European periphery economies but if growth subsides the great performance of Irish exports over the last few years may have been nothing more than a false dawn.”

INVESTORS NEED A DEBT CEILING

Ireland’s debt management agency, the NTMA, has said it needs to go back to medium-term funding markets – five and possibly 10-year bonds – at the latest by the second quarter of 2013. Launching a syndicated bond, the most likely route back to market, in the last quarter of this year would be a major coup.

Most analysts expect the NTMA, which has carried out non-deal roadshows in Asia, the U.S. and Europe, to start issuing treasury bills this year to raise its profile. To make its return to medium-term funding markets, the agency may consider a five-year dollar bond, as Iceland did, which would appeal to high-yield and credit funds in the U.S. and Asia.

A more significant test of market sentiment and a bigger prize for European leaders, anxious to show that fiscal austerity works, would be a successful Irish issue of euro paper, targeting traditional buyers of investment-grade debt.

For that, investors will need reassurance that the country’s banks, at the heart of its crisis, will not come back to haunt them with further capital requirements, and its domestic economy, which has borne the brunt of the bank bailouts and EU-IMF-imposed austerity, has stabilized.

“For a deal to really fly two things have got to happen. First, the domestic economy has got to stop shrinking and second, house prices have got to stop falling,” said Padhraic Garvey, head of investment grade debt strategy at ING.

“Investors need to know where the ceiling is for debt and the way you can draw a line is for those two things to happen,” said Garvey, who believes Dublin might consider a syndicated bond in late 2012.

“Right now, there are too many things for investors to question but I think it would make sense for Ireland to have a go towards the end of this year.”

CLARITY ON BANKS IN NOVEMBER

Ireland’s decision to guarantee its banks and put the taxpayer in the firing line for most of their losses, unlike Reykjavik, which made bondholders pay, means rising mortgage arrears and falling house prices are a sovereign risk.

Ireland has probably seen the largest property downturn in Europe, with residential prices on average half their 2007 peak and commercial prices down 60 percent. There is an expectation the commercial market may stabilize this year but the residential sector is expected to keep falling due to a shortage of finance and low consumer confidence with the latest Reuters poll predicting a 10 percent median drop.

Despite this backdrop and the expectation that mortgage arrears – more than one in 10 Irish home loans are not being fully repaid – will continue to deteriorate, Ireland’s authorities are confident that the country’s banks have enough reserves to deal with the problems.

Stress tests last year under the EU-IMF bailout brought the total bailout size for Ireland’s banks to 85 billion euros. A fresh stress test on Irish banks will be published by November of this year and if, as currently expected, it shows no additional capital is required that would support a possible Irish debt issue before the end of the year.

Stabilization of domestic demand will be more difficult to come by given Ireland is in the middle of a crushing austerity program and house prices keep dropping. Most analysts do not expect personal consumption to start growing again until 2013.

Against such a hostile domestic backdrop, the Irish government is in talks with European partners and the ECB to try to reduce the cost of shoring up its banking sector, which would help it meet its fiscal targets. Ireland’s central bank governor Patrick Honohan said on Tuesday that Dublin’s efforts were “receiving close attention.”

Even if Ireland manages to tap global capital markets in the final quarter of 2012, it is unlikely to be able to rely solely on private investors for funding after 2013, when its loans from the EU and the IMF run out, and will instead probably have to apply for additional funding from Europe in that year.

Such funding would not necessarily be deemed a formal second bailout but it would come with conditions attached.

In order to qualify for additional aid, however, Ireland will have to ratify Europe’s new fiscal compact. There is a risk that ratification will require a referendum which the government may struggle to get passed. A No vote would cast doubt over Ireland’s commitment to the euro and, given that Fitch has already warned it could trigger a rating downgrade, would likely blow the country’s chances of returning to medium-term debt markets this year.

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