Tough auctions to prompt Eurozone peripheral funding rethink

LONDON, July 14 (IFR) - Peripheral sovereigns such as Italy and Spain might have to rely more heavily on syndicated deals in order to complete their 2011 funding programmes as liquidity dries up in sovereign markets and primary dealers become more and more reluctant to shoulder the risk of auctions.

This could leave these sovereigns in a precarious position as they have only completed around half of their funding for the year.

Primary dealers were encouraged to step-up to the challenge of accommodating new supply from Italy this week as failure of the auctions would have likely triggered a full melt-down in the market. Although such a move is not seen as a departure from standard market practice, it can be costly.

"The willingness of banks to support these sales is likely to diminish as the risk associated with longer dated supply is much greater and increasingly, being a primary dealer status is seen by some banks as offering insufficient financial compensation in relation to the risk of underwriting the debt currently," said a syndicate banker this week.

Although Italy was able to borrow just short of EUR5bn on Thursday, Europe's largest borrower will remain under the microscope for any signs of fatigue on the part of the investors that fund its almost EUR1.6trn of debt.

The yields on the 15-year BTP was the highest on record and the level at which the five-year was sold (4.93%) was at the highest for three years. Meanwhile, the yield on a EUR6.75bn 12-month T-Bill auction held earlier on in the week was the highest since September 2008 at 3.67%.

Any difficulty encountered by either Spain or Italy will push spreads wider again as this week's longer-dated debt sales were only the first installment of the EUR104bn Italy still has to raise this year.

LAGGING BEHIND

According to Barclays' latest research Italy had raised EUR120.9bn at the end of June out of a gross issuance target for 2011 of EUR225bn.

Italy still has EUR104bn, or 46% to finance this year, compared to Spain which has EUR44bn to raise or 47% of its 2011 gross issuance target of EUR93.8bn.

By comparison, Germany had completed 54% of its 2011 issuance by the end of June, France 62%, Belgium 74% and the Netherlands 66% of their annual funding targets. At this point last year the picture was similar for Italy although Spain was 4% more advanced with its plans.

Given the amount to be funded there is little scope for the Tesoro to reduce its planned issuance schedule irrespective of the current level of volatility in peripheral markets.

RBC Capital Markets said recently that, "apart from taps of existing issues, the Tesoro [has] already outlined its plans for this quarter to issue a new three-year (potentially on July 28), a five-year (potentially on September 13) and a 10-year benchmark (potentially on August 30)."

AUCTIONS MORE CHALLENGING

As a result of the greater uncertainty surrounding auctions Italy is likely to be encouraged to use syndication to help it reach its funding target, although recent peripheral sentiment has forced Spain to delay a 10-year sale until the autumn whereas in July 2010 EUR6bn was raised with a 10-year Bono.

Banks role in auctions may also be influenced by the reluctance of traders to provide interbank liquidity through the automated MTS platform which dried up earlier in the week.

This development was reminiscent of the loss of covered bond liquidity in 2008 before a EUR60bn ECB purchase programme helped to restore liquidity in the covered bond market which was regarded as crucial for European banks to access the capital market after the financial crisis.

A rescue scheme of this sort is precisely what some sovereign bond participants are suggesting- albeit in much larger size- to restore liquidity within the Eurozone.

The problem with this is twofold: firstly, direct intervention doesn't imply improved liquidity if there is only one buyer in the market, and secondly, which body would be deployed to undertake such a programme?

"Amongst those that are [being] discussed are some which seem unlikely, such as a large scale ECB intervention programme, a massive EFSF funded buying programme, or the like, and some that even seem unthinkable, such as the quick introduction of a much-talked about common [European] issuance," said Peter Schaffrik, head of European rates strategy at RBC Capital Markets. (Reporting Michael Winfield, Editing by Helene Durand)