Italy, Spain under pressure on bond markets as rates spike

Borrowing rates for Italy and Spain spiked to the highest levels since the global financial crisis on Tuesday amid concern their economies, the third and fourth-biggest in the eurozone, could be sucked into a debt spiral.

In its first bond auction since its credit rating was downgraded by Standard & Poor’s last week, the Italian Treasury was forced to offer sharply higher rates to attract investors to buy up 14.5 billion euros ($19.6 billion) in debt.

The rate on six-month bonds jumped to 3.071 percent compared to 2.14 percent for the last similar operation last month. It was the highest level since September 2008 when the fall of Lehman Brothers sparked a worldwide crisis.

Two year zero-coupon bonds went for 4.511 percent compared to 3.408 percent.

The difference between the yields on Italian 10-year government bonds and benchmark German bonds fell after the sale however to 370 basis points — indicating an ease in investor concern — although the spread remained high.

Spain also paid higher borrowing rates to raise 3.225 billion euros in new short-term debt, a sign of persistent tension over its sovereign debt outlook.

The sales demonstrated Italy’s and Spain’s capacity to finance their debt but at a relatively high cost, despite a major European Central Bank programme of buying Italian and Spanish government debt on the markets.

“The perception of Italian risk has increased and investors are demanding higher returns,” said Cyril Regnat, bond strategist at the French bank Natixis.

He warned that higher rates could be “damaging” for the economy because Italy’s high public debt makes the slightest change significant. Italy currently pays around 75 billion euros in interest on its debt every year.

Italian debt had been considered among the most “stable” in the eurozone because its public deficit is lower than in many other crisis-hit countries but “it has lost this status because of its political class,” he said.

After weeks of political wrangling, the government this month adopted a strict austerity plan aimed at restoring budget balance by 2013 and reduce a debt mountain of 1.9 trillion euros — equivalent to around 120 percent of output.

But Italy has struggled to restore investor confidence as the centre-right coalition has been riven by infighting and Prime Minister Silvio Berlusconi has been mired in legal troubles and an escalating prostitution scandal.

Regnat said the rates were “damaging” for the economy since the slightest change in rates has an impact on public accounts because of the high debt.

Italy pays around 75 billion euros in interest on its debt every year.

Spain meanwhile has promised to reduce its annual public deficit from the equivalent of 9.2 percent of gross domestic product last year to 6.0 percent of GDP this year, 4.0 percent in 2012 and 3.0 percent — the EU limit — in 2013.

It is now scrambling to raise extra money in 2011 to meet those targets — telling firms to pay tax installments early, lowering state spending on medicines and stimulating new home purchases with a tax cut.

Each year of deficit pushes up overall debt, which grew to 65.2 percent of GDP as of June 30 from 57.2 percent a year earlier.

Earlier this month, the government passed a constitutional reform to limit future budget deficits and curb the accumulated debt, trying to prove its determination never to slide deep into the red again.