Analysis: ECB's bond incentive carries own risks

LONDON (Reuters) - The European Central Bank has given investors a clear incentive to buy Spanish and Italian bonds that mature sooner rather than later, creating the risk that these countries will struggle to sell longer-dated debt.

Such a development would force Spain and Italy to tap the bond markets more frequently for money and make them more vulnerable than they are now to swings in investor sentiment.

The premium that investors demand to hold 10-year Spanish or Italian bonds rather than two-year paper has ballooned since ECB President Mario Draghi said on Thursday any new ECB purchases of government bonds would focus on shorter-dated maturities.

The gap between the yields on Spain's 10- and two-year bonds has leapt by nearly a full percentage point in the past 24 hours to 310 basis points. That is its widest since at least 1990, according to Datastream.

Italy is viewed as less likely to need a bailout than Spain but has seen its 2/10-year yield spread widen by a quarter to 289 basis points as its long-dated debt has also fared worse than bonds with shorter maturities.

These trends are expected to continue for at least another month and mean that Spain and Italy will find it cheaper to offer shorter-dated bonds when they next hold debt auctions.

Anything that keeps borrowing costs in check will be helpful for these countries in the short term, but analysts say current trends risk posing difficult funding choices for them.

"The aim of the ECB is to reduce the financing costs for Spain and Italy but you are increasing pressure on these countries to sell more short-term paper, which will create the grief of redemption in the next couple of years," said Alessandro Giansanti, strategist at ING in Amsterdam.

"Italy and Spain will have even more trouble in issuing longer-dated securities because there will be reduced investor demand for such paper. Also, investors will look very closely at the redemption profile and start to demand a risk premium."

Giansanti expects the Spanish 2/10-year yield spread to widen to 350 basis points in the next two weeks.

TROUBLING TRENDS

As the euro zone debt crisis has spread from Greece, Portugal, and Ireland to Spain, the euro zone's third biggest economy has already started to issue more shorter-dated paper than it did in recent years.

The average maturity of Spanish debt fell to 6.29 years in June from 6.59 years in January 2011, according to Spanish Treasury data. While monthly data is only available from 2011, that was the lowest since 2004 on annual comparisons.

This trend will become even more pronounced if investors are going to demand a hefty premium to buy longer-dated debt, which they know won't be targeted by any future ECB bond-buying program.

Given the next Spanish bond auction is on September 6, there is plenty of time for the incentive to issue shorter-dated paper to become even more marked.

"If the cost of funding is cheaper at the shorter end of the curve, and that is the sort of maturity that investors are going to be demanding, then, in the next couple of quarters, we will see more issuance in the shorter end," said Brian Barry, fixed income analyst at Investec.

SUSTAINABILITY IS KEY

Some fixed-income experts, such as Ciaran O'Hagan, strategist at Societe Generale in Paris, say the maturity profile of outstanding Spanish and Italian debt isn't the most pressing concern.

"In principle, longer duration is better but investors are more concerned about sustainability and that depends on getting attractive rates," he said.

Spanish two-year bond yields have fallen to 4.05 percent, nearly a full percentage point below Thursday's peaks and below a euro-era high of 7.18 percent set on July 25. Two-year Italian yields dropped to 3.15 percent from July peaks of 5.3 percent.

Current yields are definitely more attractive from a borrower's point of view, but could pose risks if that prompts Italy or Spain issuing more shorter-dated bonds.

"The ECB has created some leeway in the short term as the levels of (Spanish and Italian bond) yields we are now seeing at the front end are more sustainable," said Elwin de Groot, economist at Rabobank in Utrecht.

"But if Spain and Italy start issuing shorter-dated debt as a consequence, they may give away the present from the ECB because they will have to come to market with a higher frequency and they will become more vulnerable to refinancing risk and any hiccups in sentiment."

(Reporting by Swaha Pattanaik, graphics by Vincent Flasseur and Scott Barber. Editing by Jeremy Gaunt.)