Italy 10-year borrowing costs breach 6 percent on Spain fears

MILAN (Reuters) - Italy paid a high price for the troubles of fellow problem debtor Spain on Wednesday when its 10-year bond borrowing costs topped 6 percent at auction, marking a new high since January.

A month ago Italy, with the world's fourth-largest debt pile, had raised 10-year funds at 5.8 percent. The climb in Italian yields was even sharper on a five-year maturity. The Treasury paid 5.66 percent, the highest since December, on a new June 2017 bond - 80 basis points more than a month ago.

Despite the generous yields, Italy missed the top of a planned issue range of up to 6.25 billion euros ($7.8 billion).

The volume of bids for Wednesday's 5.73 billion euro auction was broadly in line with a month ago, but analysts said the fact that the bonds were sold at a discount compared with market levels was a sign of weakness as Spain's struggle to prop up its debt-laden banks fed fears around the euro bloc.

"We're seeing Italy being taken hostage by the Spanish concerns. The market does not discriminate anymore," said Michael Leister, rate strategist at DZ Bank in Frankfurt. "You either buy periphery as a whole or you sell it. The market isn't happy with this auction."

Italian bonds suffered heavy losses in the secondary market ahead of the publication of the auction results. Benchmark 10-year yields stood at 6.13 percent by 1027 GMT, more than 480 basis points above equivalent German yields.

In a sign of growing market stress, the yield gap between Italy and Germany on a shorter two-year maturity was not far from that level, at over 450 basis points.

The threat of Greece leaving the euro zone together with Spain's problems have refueled wariness of weaker euro zone borrowers among international investors, who are estimated to now hold only about a third of Italy's total debt.

"The deterioration of peripheral markets appears to be accelerating, which is mainly a function of stress stemming from Spain's banking sector and the Greek exit risks," said Peter Chatwell, a strategist with Credit Agricole in London.

Volatility and risk-aversion on government bond markets are expected to remain high ahead of a Greek election in mid-June, which is crucial to determine the country's future as a euro member, complicating Italy's debt issuance plans.

The Italian Treasury has met so far slightly less than half of an estimated bond issuance target of around 215 billion euros for this year.

Although Italian bonds have largely outperformed Spanish ones lately, analysts said Rome would likely suffer if Spain were to ask for international support or boost debt issuance in a bid to shore up its banks and its overspending regions.

Italy raised a total of 18.5 billion euros in new debt this week. Yields hit their highest since December both at a six-month bill auction on Tuesday and at a sale of two-year paper the previous day.

(Additional reporting by London government bond desk; Editing by Ruth Pitchford)