Italian bonds continue to lag Spain on political uncertainty
* Italian lawmakers delay showdown over Berlusconi
* Spanish yields edge further below Italian ones
* Demand at ten-year German bond sale lacklustre
By Ana Nicolaci da Costa and Marius Zaharia
LONDON, Sept 11 (Reuters) - Spain's 10-year bond yields edged further below those of Italy's on Wednesday as investors fretted about the future of Rome's fragile ruling coalition and plans by its treasury to issue more debt this year.
Lawmakers held fire on Tuesday on a vote on whether to expel Silvio Berlusconi from the Senate following his conviction for tax fraud after allies of the former premier threatened to topple the government. The debate resumes on Thursday.
Concern about the survival of the government has weighed on Italian bonds, pushing their 10-year yields above those of Spain for the first time in 18 months on Tuesday.
Italian 10-year yields fell 2 basis points to 4.53 percent while Spanish equivalents were down 3 bps at 4.49 percent, widening the spread to 3 bps from 1 bp on Tuesday.
"I don't see Italy back outperforming Spain until we get clarity on the political situation," said Alan McQuaid, chief economist at Merrion Stockbrokers.
"As things stand I would be buying Spain against Italy."
The Italian Treasury has asked to raise the ceiling on this year's net debt issuance by 18 billion euros ($24 billion) to 98 billion, highlighting the difficulty Rome is having in reining in the public finances and putting more pressure on it to float good volumes at upcoming auctions.
The higher issuance will increase Italy's public debt, already targeted at 130 percent of output this year, the second highest ratio in the euro zone after Greece.
In contrast, Spain is reducing the size of its auctions for the rest of the year, after frontloading most debt sales earlier this year to take advantage of benign market conditions and putting it in a more comfortable funding position.
A fall in borrowing costs has also facilitated Spain's ability to raise funds in the market. The average interest rate paid on new debt issued by Spain's Treasury is 2.61 percent so far this year and has only been lower in 2009 and 2010 since the launch of the euro, according to Treasury data.
ITALY AUCTION TEST
The political situation and the updated issuance plans make for a difficult backdrop to an auction on Thursday of three- and 15-year Italian paper.
Some in the market expected the gap with Spain to widen further ahead of a sale, although demand from Italy's huge domestic financial sector should provide support.
Italy's underperformance versus Spain could pause once the supply is out of the way, but Italian bonds would remain vulnerable to a government crisis, Marc Ostwald, strategist at Monument Securities said.
"If the government fails, you've really got to start thinking 5 percent on 10-year and then see how bad it gets," Ostwald added. "When you've got this combination of the economy not doing much and a decent amount of budget slippage, the prospect of going into new elections and leaving Italy in limbo is not a good one."
A pick-up in yield was not enough to secure strong demand at a German auction as the possibility of a diplomatic deal on the Syrian stand-off hurt demand for safe-haven assets.
Investors dumped German bonds on Tuesday as Syria accepted a Russian proposal to give up chemical weapons to avoid a possible U.S. military strike.
Germany sold 4.076 billion euros of its new 10-year debt attracting the same demand as at a similar sale in August despite the higher yield on offer.
Despite this, German Bund futures closed 37 ticks higher after falling to 1-1/2 year lows the day before.
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