Italian borrowing costs fell at an auction hours after Moody'sInvestors Service downgraded the country's bond rating by twolevels, citing the worsening political and economic outlook.

Italy sold 3.5 billion euros ($4.3 billion) of three-year bonds,matching a maximum target, and later sold 1.75 billion euros ofthree longer-dated securities. The Rome-based Treasury sold the2015 bond at 4.65 percent, down from the 5.3 percent on asimilar-maturity bond sold on June 14. Investors bid for 1.73 timesthe amount offered, up from 1.59 times last month.

“The cut to Italy's credit rating had been more or less pricedin,” Nicholas Spiro, managing director of Spiro Sovereign Strategy,a London-based firm specializing in sovereign-credit risk, said ina note. “Domestic banks continue to hold the fort at Italianauctions. The concession, however, is still hefty and reflects theincreasing risks in Italy.”

Moody's earlier lowered Italy's rating to Baa2 from A3 and saidfurther cuts are possible because the nation's economic outlook has“deteriorated,” according to a statement. The new rating is twolevels above junk and one grade higher than Spain, according todata compiled by Bloomberg.

The yield on Italy's 10-year bond rose 8 basis points at 1 p.m.in Rome to 5.99 percent. That left the difference with comparableGerman debt at 475.7 basis points.

The Treasury also sold 600 million euros of a 5 percent 2022bond at 5.82 percent, 384 million euros of a 4.75 percent 2023 bondat 5.89 percent and 766 million euros of a 4.25 percent 2019 bondto yield 5.58 percent.

Italian Prime Minister Mario Monti has complained that concernsover Spain's banks, which are being bailed out by the EuropeanUnion, have spilled over into Italy, pushing up borrowing costs.Monti has lobbied EU leaders to give the euro bailout fund moreleeway to buy the bonds of countries meeting their fiscalcommitments.

In order to shield the euro area's third- and fourth-largesteconomies from the resurgent debt crisis, finance ministers workedout a way for the fund to intervene in bond markets and said thefirst 30 billion euros of as much as 100 billion euros in rescueloans will start flowing to Spanish banks this month.

'Right Direction'

“While contagion risks remain on the table, we think that thelatest decisions undertaken at the European level and also bySpanish and Greek governments go, if anything, in the rightdirection of giving more stability to the euro area as a whole,”economists at Barclays Capital including Fabio Fois wrote in a notebefore the auction.

Italian leaders said today that the downgrade doesn't reflecteconomic and fiscal fundamentals. Italy is “stronger” than what theratings company says, Giorgio Squinzi, head of the country's mainemployers lobby Confindustria, told reporters in Rome.

Economic Development Minister Corrado Passera, also speaking inRome, said the downgrade was “completely unjustified.” Markets“will give us this recognition over time because the government'swork will continue as strong as before.”

Recession-hit Italy will record a structural budget surplus, netof the economic cycle's effects and one-time measures, of 0.5percent of GDP in 2013, the International Monetary Fund said in aJuly 10 report. Still, with debt set to rise to 125.8 percent ofGDP this year before peaking at 126.4 next year, Italy isstruggling to shake off the risk of contagion.

“The current government's strong commitment to structuralreforms and fiscal consolidation has moderated the downwardpressure on Italy's government bond rating,” Moody's said. “Moody'srecognizes that the government has proposed, and is legislating, areform program that has the potential to materially improve Italy'slonger-term growth and fiscal prospects.”

Moody's said that its negative outlook reflects the “view thatthe risks to implementing” reforms aimed at reviving the economyand containing debt “remain substantial.” It added that “thepolitical climate, particularly as the spring 2013 elections drawnear, is also a source of implementation risk.”

Monti said July 10 that he won't serve in another governmentwhen his term ends next year. The premier made the comments afterspeculation in the Italian press about the possibility that hewould be asked to remain in office after elections due inApril.

Rivals in Parliament

The nation's two main political parties, which have suspendedtheir rivalry to jointly support Monti's policies, may not be ableto win a governing majority in parliament on their own, pollsindicate.

Former Prime Minister Silvio Berlusconi, 75, will probably leadhis People of Liberty party into the next elections due by April2013, the party's Secretary General Angelino Alfano said July 11.Berlusconi resigned in November at a time when Italy's 10-year bondyield topped 7 percent and turned the government over to Monti.

The news that Berlusconi may seek premiership next year “willnot be received well by the markets,” Spiro said. “The risk is thatinvestors start to fret about a more unstable and populistpost-Monti political landscape.”

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