Italy and Germany successfully sold bonds on Wednesday, but the stark contrast in their borrowing costs underscored investors' fragile faith in Italian debt and the perceived safety of German debt.
The rise in Italy's borrowing costs at Wednesday's auction to a euro era high will do little to allay fears over the country's ability to continue raising funds at sustainable levels, with Barclays Capital estimating Italy will need to sell around €220 billion of bonds in 2012.
Italian and Spanish bonds remain under pressure as markets were left disappointed with the lack of concrete measures at a summit of European leaders last week, and the European Central Bank appears reticent to aggressively buy the bonds.
In comparison, Germany continues to find favor, despite the possibility of the country losing its coveted triple-A rating and historically low yields, as investors look to protect the quality of their balance sheets and seek high-quality collateral which they can use to borrow funds.
German two-year yields are sitting close to their record lows while yields on some bonds have even turned negative, showing that fears of contamination of Germany's credit quality that followed an extremely weak 10-year bund auction last month, were likely premature.
Bond market investors have seen the 7% mark on Italy's 10-year bonds as crucial as a sustained rise in yields beyond that level toppled Greece, Ireland, and Portugal and forced them into seeking external assistance.
To be sure, while Italy still runs a primary surplus, which means it only needs to roll over debt, its ratio of public debt to gross domestic product is still uncomfortably high.
A sharp rise in bond yields, if sustained for a long time, would cause Italy's debt-servicing costs to soar.
The yield on Italy's benchmark 10-year bund is currently at 7.02%, down one basis point, while the five-year yield is at 6.62%, down 12 basis points on the day.
Italy sold the maximum targeted €3 billion of the 4.75% September 2016-dated BTP. Despite the satisfactory demand for this small-size auction, however, it was forced to pay a 6.47% yield, the highest on a five-year Italian auction in the euro era. At the previous auction on Nov. 14 of the same BTP, Italy paid a yield of 6.29%.
Germany, which completed its 2011 funding with Wednesday's auction, sold €4.18 billion of the 0.25% December 2013-dated schatz, paying an average yield of 0.29%, below the 0.39% level of the previous auction Nov. 16.
The amount of incoming bids exceeded the €5 billion offer size.
Demand for Wednesday's tender was also supported by around €18 billion of German bond redemptions this week.
Italy's funding costs, along with those of Spain, remain under pressure as investors, also spooked by Standard & Poor's Services warning of downgrade of euro-zone sovereigns, still seek a more comprehensive solution to the euro zone's debt crisis, including a more active role from the ECB.
Despite the European Union's summit decisions last week to enhance fiscal discipline and integration across the region, "the lack of a firmer commitment from the ECB keeps up the pressure on both the Spanish and Italian governments to protect their multi-year budget deficit reduction plan in the face of slower economic activity, while continuing to pursue growth boosting structural reforms," said Raj Badiani, economist at IHS Global Insight.
Some analysts, along with the Bank of International Settlements argue that Italy, which has the third largest bond market in the world, can withstand elevated funding costs for the some time, provided it retains access to the market.
Italy's year-end auction offer sizes are small and so relatively easy to absorb but the picture will change from January. Reducing offer sizes won't be an option in January, "especially ahead of the €26 billion BTP redemption and €10 billion coupon payments on 1 February," said Citigroup analysts in a note, who estimate Italy's BTP issuance in January in the region of €14.25 billion.
read more: Olympus Wealth Management
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