Italian downgrade highlights fragility of Spanish debt
* 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) - Spanish bonds underperformed most other euro zone debt on Wednesday after a downgrade of Italy raised fears the bloc's most indebted states are vulnerable to further credit rating cuts.
Rated one notch above 'junk' by Moody's and Standard & Poor's, Spain is seen as the euro zone country most at risk of losing investment-grade status, which would force investors that track bond indexes with minimum rating rules to sell its debt.
Italy was downgraded by S&P late on Tuesday to BBB, two notches above the speculative-grade category, although it left the country's rating outlook at negative. That is in line with Moody's Baa2 rating, while Fitch assigns a slightly higher BBB+.
"The expectation now is that Spain is going to be next," said Gianluca Ziglio, executive director of fixed income research at Sunrise Brokers.
"The rating element could be the front-door route for Spain to get into a bailout programme. If Spain gets out of the bond indexes it will have an impact on other countries as well."
Spanish 10-year yields were last 11 basis points higher at 4.80 percent, while equivalent Italian yields rose 7 bps to 4.47 percent. Only yields on illiquid Greek debt rose more.
Data on how many funds are tracking the bond indexes Spain is part of was not readily available. But analysts expect the market impact of any rating cut, while significant, would be far more limited than in early 2012, when forced selling after Portugal was downgraded to junk sent its bond yields soaring into double digits.
About two thirds of Spain's total debt is now held by domestic investors, who are unlikely to consider its rating. Meanwhile, some of the selling pressure might be absorbed by foreign hedge funds betting that the European Central Bank will make good on last year's as-yet untested bond-buying pledge.
The ECB's promise to buy bonds of euro zone countries that ask for help has helped halve the premium paid by Italian and Spanish 10-year bonds over German Bunds in the past year.
The Italian/German 10-year yield spread was last 282 bps, 6 bps wider than Tuesday's close. It was 30 bps more than this year's low, hit in May, but still 25 bps below June's highs.
"The downgrade is a signal we are not ready to outperform for an enduring period in the periphery," BNP Paribas strategist Patrick Jacq said.
"But domestic dominance is a clear support for Italian debt, not only the (extent) of it but also the breakdown."
According to Bank of Italy data, local 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.
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 was 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. Italy's one-year debt costs rose to their highest level since March at an auction on Wednesday but remained little over 1 percent.
Comments on Tuesday by ECB policymaker Joerg Asmussen indicating the bank would keep rates low for more than a year helped limit the market reaction to the downgrade. Investors were also wary of making big bets before the release later of minutes of the Federal Reserve's June meeting and a speech by Fed chief Ben Bernanke that could clarify when the U.S. central bank will begin withdrawing its massive monetary stimulus.
"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.