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MILAN (Reuters) - Italy's borrowing costs rose to 5.84 percent at a benchmark 10-year bond auction on Friday, their highest level since January, after a credit ratings cut for Spain overnight added to markets' concerns about the debt of weaker euro zone countries.
The two-notch downgrade by rating agency Standard & Poor's weighed on euro zone bond markets ahead of the Italian sale, further increasing the cost the Treasury had to shoulder to sell 5.95 billion euros in bonds.
Investors are wary of the challenge Italy faces in trying to reduce its debt burden while hauling its economy out of recession.
In a reassuring sign for the markets, the amount sold was close to the maximum 6.25 billion euros Italy had indicated it hoped to raise, although the yields the Treasury had to accept underscored the fragility of investor confidence.
"These acceptable results certainly came at a price which, in turn, leaves a question mark over how long Italy will be able to finance itself at levels that can be deemed sustainable," said Richard McGuire, a strategist at Rabobank in London.
Analysts said the Treasury had set a lower minimum size than usual, widening the range of what it would potentially raise at the sale, to hedge against risks of weak demand in the face of highly volatile euro zone bond markets.
Italy sold new tranches of its May 2017 and September 2022 bonds. It also sold two lines maturing in April 2016 and February 2019 which it no longer issues on a regular basis.
The 10-year auction yield rose 60 basis points from the last sale a month ago, approaching the sensitive 6 percent threshold. A sustained break of 6 percent in 10-year yields could see borrowing costs accelerate to unaffordable levels which drove Greece, Ireland and Portugal to seek international bailouts.
Five-year auction yields rose to 4.86 percent from 4.18 percent at the previous sale of the same bond in late March.
Five- and 10-year debt costs are now at their highest since January, having erased a fall recorded in February and March when cheap European Central Bank funds allowed Italian banks to ramp up purchases of domestic bonds.
But budget and banking troubles in Spain have hurt market confidence in the euro zone's peripheral economies, reversing the fall in yields.
S&P cut Spain's credit rating to BBB+ late on Thursday. It now rates Spanish and Italian debt at same level, with a negative outlook on both.
By the end of this month Italy will have refinanced some 90 billion euros of bonds maturing between February and April - a task that seemed almost unmanageable last November when the country was seen at risk of a Greek-style debt crisis and 10-year yields hit a euro-era record at auction of 7.56 percent.
A Treasury official said on Friday Italy had met more than 43 percent of an overall gross funding target of between 440 billion and 450 billion euros for 2012 after the latest sale.
Italy has virtually no medium or long-term debt maturing in May and June, but must repay or refinance another 100 billion euros of debt maturing in the second half of the year.
Saddled with the world's fourth-largest debt pile and chronic growth problems, Italy needs to woo back foreign buyers to support sales of longer-dated bonds over the medium term.
Italy's central bank said on Thursday foreign investors were still net sellers of its medium- and long-term debt in the first two months of 2012, after cutting their holdings in the second half of last year to 40 percent of total debt from 47 percent.
Deputy Economy Minister Vittorio Grilli said Chinese officials had expressed "cautious interest" in foreign debt at a meeting on Thursday, at which he had sought to promote investment in Italian assets, including government bonds.
Additional reporting from London and Milan government bonds teams; Editing by Catherine Evans