Italy will probably have to accept higher borrowing costs on the new five-year bond it is offering later on Tuesday because growing fears of domestic political instability are making investors edgy.
A weekend threat by former premier Silvio Berlusconi to bring down the government led by technocrat Mario Monti pushed up Italian long-term yields on Monday.
Monti dismissed fears that his government could fall but investors saw Berlusconi's warning as a wake-up call to factor in more volatility in the run-up to a general election due by April 2013.
"The treasury is likely to pay a higher yield on the new five-year benchmark, but it will put on a brave face and carry on with it," said Matteo Regesta, bond strategist at BNP Paribas in London.
"Political uncertainty will take its toll on Italian debt."
Adding to the confusion, preliminary results from a local election in Sicily showed strong gains for the anti-establishment 5-Star Movement of comic Beppe Grillo. The island has a long history of mismanagement and Fitch downgraded its credit rating to two notches above junk on Monday.
The Italian treasury will offer up to 4 billion euros of a new five-year BTP bond maturing November 1, 2017, paying a coupon of 3.5 percent, down from 4.75 percent of the current benchmark. It will also sell 10-year debt for up to 3 billion euros.
Late on Monday the new five-year bond offered a yield around 4 percent on the unofficial grey market and the rate is expected to rise further on Tuesday morning as investors sell the old paper to make room for the new bond.
Analysts say the treasury is prepared to pay higher yields to sell the maximum targeted amount of 4 billion euros. At a similar auction in late September, it paid 4.09 percent to sell five-year paper.
The yield rise on this maturity however is expected to be limited and 10-year borrowing costs may even come out a tad lower than a month ago because the treasury is selling a lower amount and is reopening an existing bond offer.
"The market will have to get used to higher volatility as Italy approaches elections next spring, but I don't expect anything dramatic," said Chiara Manenti, bond analyst at Intesa SanPaolo.
On Monday Italian 10-year yields rose 9 basis points to just above 5 percent, going back to levels not seen since October 12.
The treasury paid a yield of 5.24 percent on the 10-year maturity at a similar auction one month ago.
The successful mid-October sale of a BTP Italia inflation-linked bond, which raised a whopping 18 billion euros, has temporarily eased funding pressure for Italy before year-end.
If the treasury sells its maximum targeted amount on Tuesday, it will have covered just over 90 percent of its borrowing needs for the year.
(Reporting by Francesca Landini; Editing by Ruth Pitchford)