* Italy sells 6.9 bln euros of 5- and 10-yr bonds
* Prolonged political uncertainty, Cyprus fallout hit demand
* Italy's 5-yr debt costs rose to highest in 5 months
* Rumours Moody's will downgrade Italy rattling investors
By Francesca Landini
MILAN, March 27 Italy paid more to borrow over
five years than it has since October at an auction on Wednesday
as lack of progress in forming a new government and worries
about Cyprus's bailout hit demand, although 10-year costs fell.
The treasury sold 3.91 billion euros ($5 billion) of a new
June 2018 bond at a yield of 3.65 percent, more than the 3.59
percent it paid to sell similar paper on Feb. 27, two days after
an election in which no party won enough seats to govern.
Borrowing costs had leapt around two-thirds of a percentage
point at the February sale on fears that a prolonged political
stalemate would stall reforms needed to revive Italy's stagnant
economy and address its massive 2 trillion euro debt pile.
Centre-left leader Pier Luigi Bersani has been in talks with
rival parties this week to try to form a government, but there
is little sign he can muster enough seats to do so and Italians
may have to return to the polls, dragging out the uncertainty.
Investors' nerves are also jangling after Monday's bailout
deal for Cyprus, which imposed tough conditions including heavy
losses for senior bank bondholders and large depositors, and
which they fear may become a model for future euro zone rescues.
Persistent market rumours that credit rating agency Moody's
is about to downgrade Italy because of the political uncertainty
and weak growth outlook have also unsettled investors.
Italy's five-year funding cost on Wednesday was the highest
since October, shortly after the European Central Bank pledged
to buy bonds of struggling euro zone countries that seek help.
"Overall it looks like a rather weak auction. Volumes seem
all right ... but when we turn to the pricing side it looks
quite weak," Commerzbank senior strategist Michael Leister said.
Demand was weaker than at previous auctions, with five-year
bond drawing bids worth 1.22 times the amount sold versus an
average this year of 1.4, and the 10-year bond covered 1.33
times compared with a 2013 average of 1.48.
But Rome paid less than a month ago to sell 3 billion euros
of 10-year bonds - 4.66 percent versus 4.83 percent, the lowest
level since January - and the auction raised almost the maximum
targeted amount of 7 billion euros. Ten-year funding costs had
risen sharply in February, immediately after the election.
"The rate on the 10-year bond was in line with the secondary
market, while the one on the five-year bond was 2 basis points
higher," said ING fixed-income strategist Alessandro Giansanti.
"This means that the treasury had to give a discount even after
the big fall seen in secondary market prices before the sale."
The yield on Italy's benchmark 10-year bond was
about 13 basis points higher on the day at 1430 GMT as its debt
underperformed euro zone peers following the sale, which also
boosted safe-haven U.S. and German bonds and hit shares. The
cost of insuring Italian and Spanish debt against default rose.
The euro slumped to a four-month low against the dollar, hit
by the auction and concern about Cyprus, which is finalising
capital controls to prevent a run on its banks when they reopen
on Thursday for the first time since the bailout.
Grim euro zone economic data reinforced the bearish tone.
Analysts said yields might climb further while the country
remains in political limbo, although the ECB's as-yet untested
bond-buying pledge continues to provide a powerful backstop.
The stalemate in Rome continued on Wednesday after overtures
by Bersani to ex-comic Beppe Grillo's anti-establishment 5-Star
Movement were flatly rejected.
Bersani will update President Giorgio Napolitano on his
efforts on Thursday. If he cannot secure enough support,
Napolitano may appoint a respected outsider to try to form a
technocratic government or cross-party coalition, or failing
that, call a new election.
"We are in a volatile period that will probably continue.
Much depends on the development of the political situation,"
said Giansanti, adding that Italy was at a "critical moment".
"If the country is not able to form a government in the
short-term it will face a high risk to be downgraded by both
Moody's and Standard & Poor's, with a negative fallout on the
(yield) spread," the analyst said.
The Treasury declined to comment on Wednesday on rumours
about a downgrade, while Moody's told Reuters it was watching
Bersani's attempts to form a government and its implications for
The rating firm also warned that the euro zone's awkward
handling of Cyprus's bailout had put additional pressure on
sovereign ratings in the bloc, including that of Italy.
Moody's rates Italy Baa2, two notches above "junk" grade,
with a negative outlook, while Standard & Poor's assigns the
country a BBB-plus with negative outlook.