* Significant unwinding of "carry trade" is not expected
* Core banks seen paying back more than periphery lenders
* Markets still see value in holding Italian, Spanish bonds
* Strong demand for Italy, Spain debt sales this year
By Ana Nicolaci da Costa and William James
LONDON, Jan 24 Spanish and Italian bonds should
weather the first repayments of loans made by the European
Central Bank to prop up ailing banks a year ago and which helped
halt a spike in yields that threatened the countries' solvency.
Banks have their first opportunity on January 30 to repay
the ultra-cheap three-year loans extended by the ECB in late
2011 and early 2012 to keep money flowing through the banking
system at the height of the euro zone crisis.
The euro zone's central bank will announce on Friday how
much of the 1 trillion euros it lent banks intend to pay back
next week, with early repayments of about 100 billion euros, or
one-tenth of the total, expected.
While many lenders chose to hold cash they borrowed at the
ECB for a rainy day, Spanish and Italian banks were more
inclined to plough it into their own country's high-yielding
sovereign bonds in so-called "carry trades".
They are seen as less likely to pay back their loans at the
earliest opportunity, which should mean they continue to hold
the bonds they bought and on which they are likely to have made
big profits as the crisis has eased.
Even if there are sellers, the ECB's promise in September to
buy bonds issued by struggling states has calmed investors'
nerves enough to ensure the bonds are snapped up, analysts said.
"I don't think there is a pressing urge to unwind these
trades," said Peter Schaffrik, head of European rate strategy at
RBC Capital Markets. "I would suspect that if they - the Spanish
banks - start selling, there are probably some other takers out
there who will pick up the slack."
Central bank data illustrates the surge of investment by
Spanish and Italian financial institutions in government bonds
since the ECB's first offering of cash to banks, or long-term
refinancing operation, in December 2011.
Spanish and Italian government bondholders: link.reuters.com/kux87s
Italy and Spain government bond yields: link.reuters.com/gat45t
The proportion of Spanish government bonds held domestically
was 64.6 percent in November 2012, having jumped from 44.5
percent a year earlier. Domestic holdings of Italy's bonds rose
to 66.7 percent in October from 60.3 percent in November 2011.
Only a mass unwinding by banks in these countries of carry
trades - in which an investor uses funds raised at low cost to
buy an asset offering higher returns - would put their sovereign
bonds under serious selling pressure.
The lucrative nature of the trade makes that unlikely.
Spanish and Italian 10-year bonds still yield 5.04 percent
and 4.19 percent respectively after
plunging 176 and 332 basis points apiece since November 2011,
while the ECB loans carried an interest rate of 0.75 percent.
Spanish banks took roughly 260 billion euros of ECB loans
and are likely to return some of that. A source at the country's
fifth-largest lender Sabadell said this month it will pay back
10-20 percent of 24 billion euros it borrowed.
Friday's headline repayments figure will not contain a
breakdown of which banks have paid back what, and will not show
the extent to which banks have sold off peripheral bonds to
raise cash to return to the ECB.
Even if the number is above consensus, suggesting a possible
start to unwinding of carry trades, growing demand among foreign
investors may be sufficient to keep yields from rising sharply,
analysts said. Spain's and Italy's 2013 funding has got off to a
stellar start, attracting strong demand at auctions and for
syndicated sales of longer-dated bonds.
A willingness to hand back the ECB's loans might also be
considered a sign that the struggling banking system is on the
mend and could even boost wider investor demand for sovereign
debt, mitigating any selling pressure.
"For the banks to be able to pay it back, they need to have
the cash," said Francis Yared, head of rates strategy at
Deutsche Bank. "And if they have the cash, it means that we are
likely (to be) in an environment that is positive for the
peripheral bond market."
(Graphics by Vincent Flasseur; Editing by Swaha Pattanaik and