Italy's bonds have made sizzling returns this year but fears the country will lose its investment-grade status are putting off long-term investors whose support Rome needs to tackle a mountain of refinancing and ease worries about its debt.

Potential buyers worry that further downgrades would prompt Italy's removal from benchmark indices tracked by passive bond funds and exchange-traded funds, which would then be forced to dump their holdings. To make matters worse, credit worries are also distorting the market for Italy's inflation-linked debt.

With a combined 93 billion euros held in Europe, the behavior of such funds is critical to the performance of Italy's government bond market, the world's third largest.

JP Morgan estimates approximately 140 billion euros of Italian debt is still held worldwide by managers who track global or euro government bond benchmarks, of which Italy's debt takes about a 20 percent share.

Italy is currently rated a mid- or low-investment grade by the three major ratings agencies, but is seen as vulnerable to further downgrades. An across-the-board cut to junk would trigger its exclusion from top-rated government bond benchmarks and force passive index trackers to automatically sell the debt.

They are on the cusp of exiting some of the indices. Ratings drive benchmarks and it's legally binding. It's absolutely critical for market action, said Richard Batty, investment strategist at Standard Life Investments, which has $233 billion under management.

Citing Greece's 2010 downgrade to junk as a precedent, JP Morgan warns central bank reserve managers might also be forced to offload their 65 billion euros of Italian government debt if the sovereign were to lose its investment-grade status.

Central banks often hold their euro currency reserves in the form of government bonds.

Despite these worries, and concerns about the stability of the wider euro zone, Italy's are among the best-performing government bonds this year, with total returns of more than 8 percent on its benchmark 10-year debt.

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Demand for its paper has largely been driven by domestic banks, which have used some of last month's cheap loans from the European Central Bank to lock in higher yields on euro sovereign bonds, and those of Italy in particular.

The ECB lent almost half a trillion euros at December's unprecedented three-year operation, kick-starting a recovery in global markets, and is expected to inject another 325 billion euros at a second such tender this month.

Liquidity provisioning from the ECB is boosting carry trades, but it's not the proper sorting out of the fiscal problem, said Batty. It's a bit of a false market. It's very difficult for us long-term investors to touch that market.

He said Standard Life's clients are asking the Edinburgh-based fund not to invest in Italy and other peripheral debt, given that the recent rally does not eradicate the risk of further downgrades.

Italy is currently rated BBB+ by Standard & Poors, A2 by Moody's and A- by Fitch, respectively three, five and four notches above junk grade. Typically, all three agencies would need to strip a country of its investment-grade status before it is removed from the relevant indexes.

According to data from Lipper, index-tracking European bond funds were the only type of funds that attracted inflows in the first 11 months of 2011, with net sales of 2.2 billion euros.

Passive bond funds have been particularly popular in recent years: total net assets have risen almost 60 percent since late 2007, to 56 billion euros.

DISTORTED MARKET

Concerns about Italy's credit quality are also distorting the market for its inflation-protected bonds, which again account for more than one-fifth of European inflation-linked debt indices.

Linkers are traditionally bought by highly conservative investors as a hedge against future inflation and, as government securities, are supposed to be free of credit risk.

But giant bond fund manager PIMCO thinks Italian linkers now carry a credit and liquidity premium rather compensating purely for inflation risks, making it difficult for the investor to assess whether they offer adequate returns.

The fund estimates the breakeven rate - the average inflation rate which must be exceeded for a buyer to make money - on Italian inflation-linked bonds is about 80 basis points from where it should be, undermining demand for such assets.

Investing in euro zone inflation-linked bonds is in essence a levered call on the issuer's credit quality, PIMCO said.

BENCHMARK PROBLEMS

Because government bond benchmarks, unlike equity indexes, are weighted according to market capitalization, the more debt a sovereign has, the heavier its representation - something that wasn't viewed as a problem while European governments were all highly rated.

But with sovereign default fears rising because of the financial crisis, some funds are taking a new approach to calculating weightings, focusing on the issuer's ability to repay instead.

Swiss asset manager Lombard Odier Investment Managers uses a new framework that allows investors to invest in sovereign debt on the basis of a country's liquidity, macroeconomic strength and socioeconomic stability.

For example, economic growth plays a key role in the index because a faster-growing economy will collect more tax to service its debt. Countries with higher debt-to-GDP ratios, lax fiscal discipline and poor budgets have a lower weighting.

Lombard manages over 2.5 billion Swiss francs across five funds that use this approach, which it says would have offered an average excess annual return of 1.5 percent over traditional benchmarks over the past 10 years.

Apart from a few new benchmarks, building customized indexes is proving difficult because of liquidity and rebalancing problems that are peculiar to the fixed income market.

We are getting an increased number of clients looking for tailored bond benchmarks. But when building benchmarks you have to not only look at the theory but also practical limitations, said Gilles Guerin, chief executive officer of THEAM, an index and alternative specialist within BNP Investment Partners.

In the bond market, when there's dislocation, liquidity goes away, so you can't get out. This will make rebalancing more difficult.

(Editing by Catherine Evans)

Fixed income