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 LONDON: Italian government debt came under pressure on Monday as the country sold five and 10-year bonds, while Portuguese yields rose to new euro-era highs on growing fears Lisbon will follow Athens in seeking a second bailout.

Greece's unresolved debt restructuring talks with private bondholders were likely to cast a shadow over a European Union summit at which leaders are due to approve a permanent rescue fund and put finishing touches to a pact for stricter budget discipline.

Worries over Greece drove the spread between Portuguese and German 10-year yields to euro-era highs and the cost of insuring Portuguese debt against default also hit fresh peaks.

Italy's longer-term borrowing costs fell at a sale of 7.5 billion euros of government bonds.

"The auction's gone well, bid/cover was better than the previous time, the yield has also gone down significantly and it looks like appetite not just for shorter-dated but for longer-dated Italian bonds as well is quite healthy at the moment," Nick Stamenkovic, bond strategist at RIA Capital Markets said.

"This is largely due to the ECB-induced improvement in liquidity following the three-year LTRO (long-term refinancing operation) in December and possibly another in late February."

Italy's 10-year yields fell 90 basis points to 6.08 percent at the sale, even after Fitch Ratings downgraded Italy's rating on Friday. Demand for the 2022 bond totalled 1.4 times the offered amount, above last year's average bid-to-cover ratio.

The sale of a new five-year bond saw weaker demand but its yield was also sharply lower.

In the secondary market, 10-year Italian government bond yields were up 22 basis points on the day at 6.14 percent, while five-year government bond yields rose 31 basis points to 5.11 percent.

Mass liquidity from the European Central Bank has helped support debt of lower-rated countries in recent weeks, pulling Italian and Spanish government bond yields further away from unsustainable levels. Investors are poised for another three-year loan offering from the ECB in February. Against this backdrop, Michael Leister, rate strategist at DZ Bank said they have been recommending an ECB carry trade. "Basically buying short-dated peripherals and looking for these curves to steepen further," he said, referring to Spain and Italy.

PORTUGAL SEEN AS A DANGER

The yield spread between Portuguese and German 10-year government bonds widened past 1,500 basis points for the first time in the euro era as investors feared bailed-out Portugal may eventually have to restructure its debt.

The spread widened by about 140 bps on the day to 1,511 bps. Two-year Portuguese yields rose more that 200 bps at 20 percent.

Short-dated debt underperformed longer-dated bonds, further inverting the yield curve, signalling mounting fears of a credit event in Portugal, increasingly seen at risk of following in Greece's footsteps.

The upfront payment required to buy 10 million euros of insurance on Portuguese debt hit a record high of 3.95 million euros on Monday, according to Markit data.

Prices are quoted "upfront" when they reach extreme levels and require the buyer of protection to pay a single lump sum instead of running premiums.

"I think Portugal is really a danger," Alessandro Giansanti, senior rate strategist at ING said.

"In the second half of this year I think they will realise that it will be impossible for Portugal to issue bonds next year (as envisaged in its 2011 bailout) and they will start talks for the new package," he said.

"Then the (question) is will a new bailout come together with a PSI or not? That's another risk," Giansanti said, referring to the requirement that Greece's private sector creditors write down some of the value of their investments.

The ongoing uncertainty over Greece and the fallout the outcome of a Greek debt swap talk could have underpinned German Bund futures. They rose 78 ticks on the day to 139.67 -- not too far from euro-era highs 140.23 hit in January.

Copyright Reuters, 2012

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