* Debt costs rise, demand falls at Italy debt sale
* Italian bonds seen facing increased volatility
* Spain extraordinary sale could benefit from Italy woes
* Low-rated sovereigns grab chance to issue bonds
By Marius Zaharia and Emelia Sithole-Matarise
LONDON, March 13 (Reuters) - Italian yields rose on Wednesday after the country’s first bond auction following Fitch’s credit rating downgrade found weaker demand than previous sales despite a rise in the premium offered to investors.
The result suggested volatile times ahead for Italy’s bonds as it tries to resolve a political deadlock following last month’s election, which prompted Fitch’s one-notch cut to BBB+.
Italian 10-year yields rose to an intraday high of 4.73 percent from around 4.65 percent at 1000 GMT, when bidding for the bonds was cut off. They were last 8 basis points up on the day at 4.68 percent.
The market reaction was described as muted by analysts, who expect the European Central Bank’s as-yet untested pledge to buy highly indebted countries’ bonds to contain the rise in yields. They saw no problems for Italy in accessing funding markets, although borrowing costs were rising.
“Given the fact that this is perceived as a structural problem rather than a liquidity problem ... funding for Italy at the moment is not a concern,” said Norbert Aul, a rate strategist at RBC Capital Markets.
“But what we have seen today was an auction which was not very strong given the fact that the overall political risk for Italy is still significant. Therefore in events like this auction, this comes to the forefront.”
At the auction, Italy offered an average yield of 2.48 percent for its three-year bonds, the highest level since December. Demand as measured by the bid/cover ratio fell to 1.28 from 1.37 at a previous sale.
The sale of a 2028 bond followed a similar pattern of higher yields and lower demand.
Reassured by Italian bonds’ resilience to the political crisis and hoping the ECB backstop will keep supporting high-yielding assets, the euro zone’s lower rated sovereigns appear to see a window of opportunity in which to issue debt.
Ireland sold on Wednesday its first new benchmark 10-year bond since soaring yields forced it to take a bailout in 2010. The government said the yield on the new debt was likely to settle around 4.15 percent, just over half a percentage point less than the 10-year yield on bonds issued by Italy, the euro zone’s third biggest economy.
On Thursday, Spain plans an extraordinary triple-bond auction which is expected to go smoothly as its debt has benefited most from Italy’s political problems, driving their yield gap closer to parity.
“As markets have now ruled out the possibility of a euro break-up, if you believe that the ECB will remain accommodative ... it means that carry trades remain favoured,” BNP Paribas rate strategist Patrick Jacq said.
“Therefore it makes sense to invest in peripherals and it makes sense for peripherals to issue at the moment. Demand is there, liquidity is there, the grab for yields persists.”
In a sign that the ECB’s bond-buying programme has so far been effective in preventing contagion, Spanish 10-year yields have fallen to their lowest levels since March 2012 this week at 4.727 percent. On Wednesday, they were 4 bps higher at 4.78 percent.
“We still favour Spain. We think the risks on the formation of a new government and (ratings) downgrades that may come afterwards are underpriced,” Societe Generale rate strategist Ciaran O’Hagan said.
Irish benchmark yields were slightly lower at 3.67 percent, compared with over 15 percent in mid-2011 when markets feared bailed-out euro zone sovereigns might not be able to raise funds on their own once their aid programmes end.
At the other end of the euro zone credit rating scale, German 10-year yields were steady on the day at 1.48 percent, while Bund futures rose 10 ticks to 143.14 as a two-year German debt sale went smoothly.