EURO DEBT SUPPLY-Italy vote nerves may complicate Spain sale

LONDON Fri Feb 15, 2013 10:43am EST

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LONDON Feb 15 (Reuters) - Spain may need to offer higher yields at its debt sale next week to counter worries over Italian elections, but renewed buying interest from domestic investors should ensure the auction goes smoothly.

The recovery of Spanish and Italian bond markets has stalled in the past month as a comeback in opinion polls by former Italian Prime Minister Silvio Berlusconi raised the prospect of a fragmented parliament which could hamper reform under the next government.

The two countries have been at the heart of the euro zone's three-year-old debt crisis for well over a year now and their bonds have often moved in the same direction.

They faced strong selling pressure at the start of this month, but that has cooled in recent days, with traders citing local banks, pension funds and other financial institutions snapping up the cheapened paper.

"Italy is now the origin of market volatility ... and Spain will have to concede something to the market," said Sergio Capaldi, fixed income strategist at Intesa SanPaolo.

"But we expect the auction will perform pretty well ... given the renewed appetite, especially from domestic investors."

Benchmark 10-year Spanish yields last traded around 5.20 percent, some 30 basis points higher than the lows seen in mid-January, but also some 25 bps lower than the February highs.

Compared with equivalent Italian debt, Spanish 10-year yields are about 85 bps higher, but Capaldi expects the election-related uncertainty to narrow the gap. Based on his forecast that Spain may grow faster than markets expect this year, Capaldi estimates the spread could shrink to 40 bps by end-2013.

Domestic investors have dominated Spanish and, to a lesser extent, Italian markets for the past year after banks reinvested cheap European Central Bank loans late in 2011 and early in 2012 in the bonds issued by respective governments.

Spain will sell 2015, 2019 and 2023 bonds on Thursday.

DEMAND FOR CORE

The tensions in peripheral debt markets are expected to keep investors cautious and boost demand for assets perceived as safe havens such as French and German debt.

France will sell between 7-8 billion euros of medium- and long-term fixed-rate bonds at an auction on Feb. 21, and 1.5-2.5 billion euros in inflation-linked bonds.

Germany will sell 5 billion euros of 10-year bonds on Wednesday.

Bund yields were last 1.63 percent, about 10 bps below February highs as weak euro zone data and worries about political developments in Italy renewed interest in the German paper.

"There is sufficient demand out there for German paper to ensure the sale goes through. To a large degree it depends on outright (yield) levels. If we see a little spike in yields as well, they should definitely be fine," said Michael Leister, senior rate strategist at Commerzbank.

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