(Corrects to “bond yields” from “bonds” in first paragraph)
By Dhara Ranasinghe
LONDON, July 4 (Reuters) - Italian government bond yields rose on Monday as worries about the country’s banks and some 20 billion euros of issuance in the region this week combined to brake a post-Brexit tumble in regional borrowing costs.
Italy’s banking sector is saddled with 360 billion euros of bad loans, a third of the euro zone total, and recent market turmoil has raised concern it might be hard for Italian lenders to raise capital in the market without triggering rules that could force losses on bond- and shareholders.
The Italian banking index fell nearly 4 percent on Monday, while the European Central Bank asked Banca Monte dei Paschi di Siena to slash its bad debts by 40 percent over three years, heaping more pressure on Rome and Brussels to stabilise the Italian banking system.
Italy is in talks with the European Commission to devise a plan to recapitalise Italian lenders with public money limiting losses for bank investors, an EU spokeswoman said on Sunday.
“If you start talking about the direct recapitalisation of Italian banks that’s not positive for Italian BTPs as it suggests a wider fiscal deficit,” said Cyril Regnat, fixed income strategist at Natixis.
The yield on Italy’s 10-year government bond or BTP rose 2 basis points to 1.17 percent, pulling away from more than one-year lows hit on Friday at around 1.04 percent .
The ECB’s 1.74 trillion euro bond buying programme and expectations of further stimulus to offset the economic fallout of Brexit has bolstered Italian, and broader euro zone bond, markets in the past week.
But concerns about Italian banks and political risks could prove a headwind for the bond market.
Prime Minister Matteo Renzi has started a campaign to win an October referendum on constitutional reform, aimed at ending Italy’s history of unstable governments. Renzi has said he will stand down if he loses, a gamble that could revive turbulence in the euro zone’s third-largest economy.
“We are looking at a potentially explosive moment for Italy, partly on the banking side and partly on the political side,” said Orlando Green, European fixed income strategist at Credit Agricole.
Italian 10-year yields rose above those of their Spanish peers last week for the first time since July 2015. Spanish 10-year yields were flat at 1.15 percent, while Portuguese 10-year yields dropped 5.6 percent to just below 3 percent.
Most other euro zone borrowing costs held steady as investors also looked ahead to new bond supply due this week.
Austria, Germany, Spain and France hold bond auctions and there is talk that Spain could also announce plans to sell new 10-year paper via a syndication to take advantage of a tumble in government yields in the past week.
Spain’s 10-year yield, which rose the day after the British vote as investors dumped risk assets, has tumbled 47 bps since then and ended Friday with its biggest weekly fall for almost four years.
As well as talk of more ECB stimulus, Spanish bonds have gained on hopes that acting Prime Minister Mariano Rajoy will be able to form a new government. His People’s Party failed to win a majority in elections on June 26 but won the most votes and increased its lead from an inconclusive ballot in December.
“The stage is now set for Spain to announce a new 10-year bond sale, with yields low and markets giving a bullish reaction to the Spanish election,” Commerzbank interest rate strategist David Schnautz said.
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