By Mike Bird 

Even as Europe prepares to tighten the monetary taps, its most fragile economies appear unfazed.

The bonds of the weakest economies have risen in value relative to ultrasafe Germany, despite expectations that the European Central Bank will reduce its stimulus--which has benefited these economies the most.

That speaks to the cautious path the ECB is treading in communicating the end of monetary policy that has shaped markets, and the more positive outlook for the region's economy and politics, investors say.

On Thursday, the ECB left its stimulus measures unchanged but signaled it would discuss how to proceed with interest rates and bond buying--part of its bid to stimulate the regional economy--in the fall.

Bond yields in nations including Spain, Portugal and Italy have dropped dramatically since the summer of 2014, when ECB President Mario Draghi first hinted that the bank would kick off a quantitative-easing program. As the eurozone's economy strengthened, investors began eyeing an end to the unprecedented stimulus.

At the start of 2017, less than a fifth of investors surveyed by Citi Research believed that peripheral European spreads would end the year lower. Yields move in the opposite direction to process prices. Nearly half believed they would end the year sharply or moderately higher.

But since December, when the ECB said it would reduce bond purchases by EUR20 billion ($23 billion) a month, Spanish, Portuguese, Irish and Greek bond yields have declined in comparison with German yields.

The spread between German yields and those on other bonds is commonly used as a measure of the risk that investors attach to holding other debt.

"We don't think we're going to see a car crash, a European government bond market tantrum," said Andrea Iannelli, fixed-income investment director at Fidelity International.

The sharpest fall in yields this year has been in Greece, where the spread against German bunds has dropped from more than 6 percentage points to around 4.5. The country, which once seemed on the verge of leaving the eurozone, received its latest bailout tranche from international creditors earlier this month, and is even considering returning to private markets by issuing its first bond in three years.

Investors have also returned to Irish and Spanish bonds, two countries where economic growth has outperformed and budget deficits have fallen sharply.

One reason for the lack of widening in spreads is the careful messaging of the ECB, said Gilles Pradere, a senior bond fund manager at RAM Active Investments.

"It's still a very dovish message that they're sending overall," said Mr. Pradere. "They talk about patience, that they're not done yet."

On Thursday, Italian, Spanish, Portuguese and Greek bonds continued to rally, in a sign that investors are becoming increasingly relaxed about holding the debt of these countries, which they once sold heavily.

Mr. Pradere said the ECB doesn't want to repeat the mistake he believes the U.S. Federal Reserve made in 2013. That May, the Fed's announcement that it would begin reducing bond-buying sparked the so-called taper tantrum, when U.S. 10-year Treasury yields rose from 2% to 3% by early September.

Many analysts now expect the ECB to announce in September a reduction in the bond-buying program for a fixed period--for example, cutting monthly purchases to EUR40 billion for a particular number of months. The Fed trimmed its buying by a set amount every month until it was no longer accumulating bonds.

Investors' concerns over the periphery have been soothed by stronger growth in the eurozone, which has recently outstripped the U.S.

"The economy is definitely in a better place than it was last year--that helps sentiment and risk appetite," said Mr. Iannelli at Fidelity International.

Worries about regional political risk that capped investors' enthusiasm for Europe through much of this year have also waned. The anti-euro political candidates that had ridden high in French and Dutch opinion polls failed to win their elections, while support for Germany's antiestablishment party have fallen.

Some analysts and investors still believe that debt markets in Europe's periphery are most exposed to tapering.

"We remain firmly biased toward peripheral spreads widening going forward," said Rabobank strategists in a recent research note. The Dutch bank said that as investors begin to price in tapering, financing costs will rise for these countries, which will feed into concern over their ability to eventually pay back debts.

Analysts say that Italian debt is most at risk from tapering. The country's government debt is equivalent to around 133% of gross domestic product, compared with 97% in France and 68% in Germany. The spread on Italy's 10-year bond is the only one among peripheral markets to not fall against Germany, though nor have they risen notably. The spread has been effectively unchanged compared with eight months ago.

Political risk in Italy hasn't faded. The country will go to the polls early next year, with the anti-euro populist 5 Star Movement regularly leading in national surveys.

"The Italian risks are just coming later, they've not been resolved," said Richard Barwell, senior economist at BNP Paribas.

Write to Mike Bird at Mike.Bird@wsj.com

(END) Dow Jones Newswires

July 20, 2017 11:55 ET (15:55 GMT)