MILAN, April 5 (Reuters) - Spain's disappointing bond auction is expected to fuel appetite for safer German debt at a 10-year bond sale next week while nervous investors are likely to demand higher yields from Italy when it offers short-term bonds on Thursday.
Madrid's borrowing costs rose at an auction on Wednesday and it sold barely more than the minimum planned amount as investors fretted about its ability to meet budget deficit goals.
Analysts see Italy as vulnerable to Spain's problems in a week when higher-rated Austria and the Netherlands are also set to tap markets with relatively small bond issues. Total supply is estimated at up to 14.8 billion euros.
"Next week's supply story is all about Italy and Germany," said Matteo Regesta, a strategist with BNP Paribas in London.
Concerns about the funding abilities of weaker euro zone members pushed their bond yields sharply higher ahead of the long Easter weekend, and drove Germany's 10-year yields to their lowest level since November.
"The Spanish sale will have repercussions on next week's auctions. Widening spreads favour Germany, spurring demand regardless of the falling yields," said ING strategist Alessandro Giansanti.
The risk premium Italian and Spanish 10-year bonds pay over German Bunds rose on Thursday, with the yield gap between Italian BTP bonds and Bunds hitting its highest level since mid-February at 380 basis points.
"Italian bonds may well cheapen more than anticipated ahead of next week's supply following the weak Spanish sale," said BNP's Regesta. "However, higher yields could stimulate demand from domestic investors. I don't seen a problem with the sale going through."
Italy is set to reopen a three-year benchmark first launched in March for up to 3 billion euros, and offer up to 2 billion euros split over three off-the-run bonds maturing in 2015, 2020 and 2023.
Demand from Italian banks rich in European Central Bank liquidity has helped Italy sell around 74 billion euros in bonds at auctions settled this year, as Rome worked its way through 90 billion euros of bonds maturing between February and April.
Reinvestment flows may also help as Italy has 15 billion euros in BTP bonds coming due mid-April.
With a healthier banking system and a less indebted private sector compared to Spain, Italy is seen in a better position. However, refinancing needs stemming from its 1.6 trillion euro bond market expose Rome to worsening funding conditions.
"The improvement in Italy's perceived creditworthiness over the past few months is being put to the test," said Nicholas Spiro at Spiro Sovereign Strategy.
"Will investors differentiate between Spain and Italy if market conditions deteriorate further?" AUCTIONS AT A GLANCE ----------------------------------------------------------- DAY ISSUER MATURITY COUPON RIC MAX AMOUNT
Tue N'lands Jan-2017 2.50% 3.50 Tue Austria Nov-2022 3.40% 0.66 Tue Austria Feb-2017 3.20% 0.66 Wed Germany Jan-2022 2.00% 5.00 Thu Italy Mar-2015 2.50% 3.00 Thu Italy Nov-2015 3.00% (*) Thu Italy Feb-2020 4.50% (*) Thu Italy Aug-2023 4.75% (*) (*) The three bonds will be issued for a total amount of up to 2 billion euros.