Italian yields edge higher after S&P cuts rating
* S&P cuts Italy one notch to BBB
* Italian yields rise, but remain within ranges
* Spain seen more vulnerable to rating downgrades
By Marius Zaharia
LONDON, July 10 (Reuters) - Italian bond yields rose slightly on Wednesday after a Standard & Poor's downgrade that raises doubts lower-rated euro zone debt will continue to outperform safer German Bunds.
S&P cut Italy's rating by one notch to BBB and left its outlook negative, citing the country's weak economic prospects and impaired monetary policy transmission within the euro zone.
Italian 10-year yields rose 7 basis points to 4.47 percent, while two-year yields rose 6 bps to 1.88 percent.
The yield premium paid by 10-year Italian paper over German debt of the same maturity rose to about 280 bps - some 30 bps more than this year's low, hit in May, but still 25 bps less than June's highs.
Analysts said market reaction had been muted as Italy's ratings remain two or three notches above "junk" grade, meaning investors have not been forced by their own credit quality rules to sell. Also, two-thirds of Italian debt is held by a relatively diverse base of local investors, which tend to hold onto its bonds.
"The downgrade is a signal we are not ready to outperform for an enduring period in the periphery," BNP Paribas rate strategist Patrick Jack said. "But domestic dominance is a clear support for Italian debt, not only the (extent) of it but also the breakdown."
The premium offered by Italian and Spanish 10-year bonds over German Bunds has halved in the last year after the European Central Bank promised to buy government bonds of countries under market pressure that ask for financial help.
According to Bank of Italy data, banks - which tend to favour short-dated bonds - held about a fifth of total Italian debt at the end of September 2012, a much smaller share than in Spain, where they hold about 40 percent.
But about a quarter of Italian debt is held by local insurance companies, pension funds, households and corporates. In Spain, insurance and pension funds, which are more likely to invest in longer dated debt, hold about 10 percent.
UniCredit strategists said in a note that Wednesday's rise in yields gave an opportunity to snap up some of the 6.5 billion euros worth of Italian bonds on offer at an auction on Thursday more cheaply.
Traders said comments on Tuesday by European Central Bank policymaker Joerg Asmussen indicating the bank would keep rates low for more than a year, and the release later of minutes of the Federal Reserve's June meeting were also limiting the market reaction to the downgrade.
"All the talk from the ECB yesterday is still putting a lid on spreads and I think there's a lot of wariness about the Fed minutes as well," one trader said.
CONCERNS ON SPAIN
Rated just one notch above junk by Moody's and S&P, Spain would be more vulnerable than Italy to a downgrade that would force investors who only hold investment-grade debt to sell.
Spanish 10-year bond yields were 8 basis points higher at 4.77 percent on Wednesday, while other indebted euro zone countries' bonds were stable.
"The downgrade illustrates that we haven't reached the bottom yet (for ratings) and it shows how worried Spain should be," said Jan von Gerich, fixed income chief analyst at Nordea.
"Spain is more immediately at risk (of forced selling). The big thing would be if Spain lost its investment-grade status."
Bund futures were 13 ticks higher at 142.69, getting some support from weak Chinese trade data.
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