Italian borrowing costs fell at an auction hours after Moody's Investors Service downgraded the country's bond rating by two levels, 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 of three longer-dated securities. The Rome-based Treasury sold the 2015 bond at 4.65 percent, down from the 5.3 percent on a similar-maturity bond sold on June 14. Investors bid for 1.73 times the amount offered, up from 1.59 times last month.

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

Moody's earlier lowered Italy's rating to Baa2 from A3 and said further cuts are possible because the nation's economic outlook has “deteriorated,” according to a statement. The new rating is two levels above junk and one grade higher than Spain, according to data 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 comparable German debt at 475.7 basis points.

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

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

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

'Right Direction'

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

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

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

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

“The current government's strong commitment to structural reforms and fiscal consolidation has moderated the downward pressure on Italy's government bond rating,” Moody's said. “Moody's recognizes that the government has proposed, and is legislating, a reform program that has the potential to materially improve Italy's longer-term growth and fiscal prospects.”

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

Monti said July 10 that he won't serve in another government when his term ends next year. The premier made the comments after speculation in the Italian press about the possibility that he would be asked to remain in office after elections due in April.

Rivals in Parliament

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

Former Prime Minister Silvio Berlusconi, 75, will probably lead his People of Liberty party into the next elections due by April 2013, the party's Secretary General Angelino Alfano said July 11. Berlusconi resigned in November at a time when Italy's 10-year bond yield topped 7 percent and turned the government over to Monti.

The news that Berlusconi may seek premiership next year “will not be received well by the markets,” Spiro said. “The risk is that investors start to fret about a more unstable and populist post-Monti political landscape.”

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Italian Yields Fall after Downgrade

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