By Ana Nicolaci da Costa and Francesco Canepa
LONDON, June 20 (Reuters) - Italy risks being pulled back to the heart of the euro zone debt crisis as the fallout from a Spanish bank bailout makes market access more expensive even though Italian economic fundamentals are seen as stronger than Spain's.
The correlation between moves in Italian and Spanish bonds has risen sharply since March, showing the increased risk attached to holding Spanish debt is feeding through to Italy.
Many in markets believe rising borrowing costs will push Spain into a sovereign bailout, damaging investor confidence in lower-rated euro zone debt such as Italy's and depleting the regional funds available if Rome needed assistance.
Spain is the euro zone's fourth largest economy and Italy the third. If Spain were to need a sovereign bailout, which many analysts predict, it would exhaust the region's rescue funds.
Contagion risk could make it increasingly costly for Italy, seen as the country most likely to fall under market scrutiny after Spain, to raise funds in debt markets in the absence of a crisis solution or further European Central Bank bond purchases.
"The market can create its own destiny and as long as there is no proper plan to fix the problem, the markets are always going to worry about the next country," JPMorgan strategist Emmanuel Cau said.
Italian bonds and stocks have outperformed their Spanish counterparts in recent months as the market focused on Madrid's deteriorating finances. A euro zone rescue plan of up to 100 billion euros to shore up Spanish banks did little to ease concerns about the country's ability to fund itself, with many analysts worrying it would add to Spain's debt.
Italy's FTSE MIB has outperformed Spain's Ibex by around 12 percentage points in the year to date, while the premium investors require to hold 10-year Spanish debt over Italian hit a record high of 112 basis points this week.
But the correlation between the two countries' bonds has risen to between 0.7 and 0.9 in recent months, where 1.0 is perfect correlation, meaning rising Spanish yields were translating into higher borrowing costs for Italy as well.
As 10-year Spanish yields hit euro-era highs above 7 percent, a level beyond which Greece, Portugal and Ireland sought bailouts, Italian yields topped 6 percent.
"If we continue to get no clear progress towards a credible solution, then BTP yields look as if they will be joining Spanish yields up around the 7 percent mark within the next couple of months," WestLB fixed income strategist John Davies said.
"In the first instance Spanish bonds (should) continue their underperformance because that's where the centre of the uncertainty is."
Higher interest payments on Italy's debt, the world's third largest, threaten the government's efforts to balance its books, feeding contagion fears and potentially impacting other assets.
"When people realise the risk of having a 6 percent yield on Italian debt, the risk premium in Italy will increase, the spread (versus the German Bund) will increase and then the only possible scenario is a correction in the Italian market relative to the Spanish one," Claudia Panseri, an equity strategist at Societe Generale said.
She expected the FTSE MIB to fall nearly 14 percent in the next three quarters, compared to a 2 percent fall for the Ibex.
Rising Italian borrowing costs mean analysts expect the Treasury to continue to skew issuance towards the short end of the curve, while relying heavily on domestic demand.
"They will need to continue to issue bonds in short maturities ... like they have done so far," Alessandro Giansanti, strategist at ING said.
"This strategy cannot be executed for a long time because you increase the rollover risk on the current debt."
For a graphic on Spanish and Italian bond yield spreads, see http://link.reuters.com/vur47s
For an economic overview of Italy vs. Spain, see http://link.reuters.com/vaz86s
In some respects, Italy is in a stronger position than Spain. I ts budget deficit is one of the lowest in the euro zone in relation to the size of the economy, whereas Spain's is one of the highest. But at 120 percent of GDP, Italy's debt as a share of output is second only to Greece's in the euro zone.
Analysts worry about Rome's ability to cut that burden during a deep recession and to turn itself around with reforms less than a year before elections.
The country's banking system is seen as sounder than Spain's. Private debt levels are low and, unlike Spain, Italy had no real estate bubble. However, some analysts say the banks could come under pressure along with the broader economy.
One worry is Italian banks' increasing exposure to their own country's debt after they used cheap European Central Bank cash to buy Italian bonds and benefit from a carry trade.
"The feedback loop between the banks and the sovereign is still intense, both in Italy and Europe, as banks continue to support sovereign issuance," Morgan Stanley said in a research note. It estimates the Italian banking sector's recapitalisation needs are between 24 and 42 billion euros.
Sanjay Joshi, head of fixed income at London and Capital said the $3.5 billion dollar fund would only consider investing in peripheral assets again if policymakers tackled meagre growth and an overleveraged banking sector in the euro zone.
"Until we get resolute steps to deal with those two aspects, we will not be increasing or adding any peripheral exposure at all either to our fixed income portfolios or to our equity portfolios," he said. (Graphics by Scott Barber, editing by Nigel Stephenson)