Spain and Italy's bonds seen shrugging off ECB loan repayments
* Significant unwinding of "carry trade" is not expected * Core banks seen paying back more than periphery lenders * Markets still see value in holding Italian, Spanish bonds * Strong demand for Italy, Spain debt sales this year By Ana Nicolaci da Costa and William James LONDON, Jan 24 (Reuters) - Spanish and Italian bonds should weather the first repayments of loans made by the European Central Bank to prop up ailing banks a year ago and which helped halt a spike in yields that threatened the countries' solvency. Banks have their first opportunity on January 30 to repay the ultra-cheap three-year loans extended by the ECB in late 2011 and early 2012 to keep money flowing through the banking system at the height of the euro zone crisis. The euro zone's central bank will announce on Friday how much of the 1 trillion euros it lent banks intend to pay back next week, with early repayments of about 100 billion euros, or one-tenth of the total, expected. While many lenders chose to hold cash they borrowed at the ECB for a rainy day, Spanish and Italian banks were more inclined to plough it into their own country's high-yielding sovereign bonds in so-called "carry trades". They are seen as less likely to pay back their loans at the earliest opportunity, which should mean they continue to hold the bonds they bought and on which they are likely to have made big profits as the crisis has eased. Even if there are sellers, the ECB's promise in September to buy bonds issued by struggling states has calmed investors' nerves enough to ensure the bonds are snapped up, analysts said. "I don't think there is a pressing urge to unwind these trades," said Peter Schaffrik, head of European rate strategy at RBC Capital Markets. "I would suspect that if they - the Spanish banks - start selling, there are probably some other takers out there who will pick up the slack." LACKING INCENTIVE Central bank data illustrates the surge of investment by Spanish and Italian financial institutions in government bonds since the ECB's first offering of cash to banks, or long-term refinancing operation, in December 2011. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Spanish and Italian government bondholders: link.reuters.com/kux87s Italy and Spain government bond yields: link.reuters.com/gat45t ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ The proportion of Spanish government bonds held domestically was 64.6 percent in November 2012, having jumped from 44.5 percent a year earlier. Domestic holdings of Italy's bonds rose to 66.7 percent in October from 60.3 percent in November 2011. Only a mass unwinding by banks in these countries of carry trades - in which an investor uses funds raised at low cost to buy an asset offering higher returns - would put their sovereign bonds under serious selling pressure. The lucrative nature of the trade makes that unlikely. Spanish and Italian 10-year bonds still yield 5.04 percent and 4.19 percent respectively after plunging 176 and 332 basis points apiece since November 2011, while the ECB loans carried an interest rate of 0.75 percent. Spanish banks took roughly 260 billion euros of ECB loans and are likely to return some of that. A source at the country's fifth-largest lender Sabadell said this month it will pay back 10-20 percent of 24 billion euros it borrowed. Friday's headline repayments figure will not contain a breakdown of which banks have paid back what, and will not show the extent to which banks have sold off peripheral bonds to raise cash to return to the ECB. Even if the number is above consensus, suggesting a possible start to unwinding of carry trades, growing demand among foreign investors may be sufficient to keep yields from rising sharply, analysts said. Spain's and Italy's 2013 funding has got off to a stellar start, attracting strong demand at auctions and for syndicated sales of longer-dated bonds. A willingness to hand back the ECB's loans might also be considered a sign that the struggling banking system is on the mend and could even boost wider investor demand for sovereign debt, mitigating any selling pressure. "For the banks to be able to pay it back, they need to have the cash," said Francis Yared, head of rates strategy at Deutsche Bank. "And if they have the cash, it means that we are likely (to be) in an environment that is positive for the peripheral bond market." (Graphics by Vincent Flasseur; Editing by Swaha Pattanaik and Catherine Evans)
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