EURO DEBT SUPPLY-Italy vote outcome clouds debt auctions
* Italy expected to sell new 10-year bond
* Vote outcome nerves could hoist borrowing costs
By Emelia Sithole-Matarise
LONDON, Feb 22 (Reuters) - Italy may have to pay a big premium to sell bonds next week if the market gets rattled by an indecisive election result that puts in doubt reforms needed to spur growth and cut the country's debt.
A sale of inflation-protected bonds on Monday will be the first test of investor demand as Italians go to the polls to choose a new government that will have to deal with the country's mammoth 2 trillion euros of public debt.
This will be followed up by an auction of an estimated 7 billion euros of conventional bonds on Wednesday, expected to include a new 10-year benchmark paper. The Italian Treasury, the sole scheduled issuer in the euro zone primary market next week, will give details of the sales later on Friday.
Markets are widely expecting the centre-left party of Pier Luigi Bersani to win the Feb. 24-25 vote and rule in coalition with technocrat centrist Mario Monti, with a comeback by former Prime Minister Silvio Berlusconi - reviled by markets - largely dismissed.
This has kept Italian bond yields steady in recent weeks after an initial sell-off in early February, with benchmark 10-year debt yields within the 4.10-4.75 percent range that has prevailed so far this year.
Nevertheless, some analysts say the market may be underestimating the risk that Berlusconi's centre-right coalition and other parties might rally strongly and leave the centre-left parties with a slim majority that could weaken their ability to push through reforms.
"The market is not fully pricing in this bad case scenario," said Ioannis Sokos, a rate strategist at BNP Paribas. "If we have a negative surprise, a hung parliament or incapacity of the left and Monti to form a strong enough coalition, we expect a strong sell-off.
"It is difficult to forecast borrowing costs but if the outcome is bad the Tesoro would need to offer a big discount in order to make the bonds attractive versus the current benchmark," he said.
The Treasury could play it safe given the uncertainty over the elections, and skip the launch of a new 10-year debt, focusing instead on shorter-dated paper that falls within the ambit of the European Central Bank's conditional bond buying scheme.
Italian 10-year bonds were last yielding 4.44 percent, 5 basis points down on the day while five-year yields were down 7 bps at 3.19 percent.
The bonds have recouped almost half of losses seen early this month as some yield-hungry investors bought back into the cheapened debt, betting too that the ECB's bond backstop would prevent panic selling.
While post-election nerves may lift borrowing costs, domestic demand backed by 6.3 billion euros in coupon payments should ensure smooth sales, analysts said.
"Overall any sort of downside will ultimately be limited by the fact that we still have a huge amount of liquidity-inspired risk-on move and the OMT (the ECB's bond-buying scheme) sitting in the background that puts a floor on any significant sell-off," said Lyn Graham-Taylor, a strategist at Rabobank.
"If they've got a slim majority it (the 10-year yield) could back up 10-20 bps. It's difficult to put a number on it. What we expect is a retracement rather than a reversal of the overall risk-on theme."