Wall Street Journal
By TOM LAURICELLA And EMESE BARTHA

LONDON—Italy’s latest bond auction on Tuesday drew more buyers than anticipated, but it didn’t enable the debt-laden country to avoid paying euro-era record-high yields to get the deal done.

The auction of up to €8 billion ($10.6 billion) in bonds over a range of maturities saw Italy paying yields of 7.89% on three-year bonds and 7.56% on 10-year paper. Despite the record yields, the auction attracted enough demand—driven mainly by domestic buyers, analysts said—to cover the amount on offer.

The outcome, though far from stellar, was enough to lift broader markets. The Euro Stoxx 50 index was up 0.5% at 2233.09, while Frankfurt’s DAX gained 0.9% at 5798.28. The euro rose and Italian bond yields, which have surged in recent weeks, were flat on the day.

Though Italy’s borrowing costs are rising to worrying levels, the country has considerable cash reserves. In the short term, a buyers’ strike, in which investors refuse to buy bonds at any yield, could pose a greater threat to Italy than the yield levels themselves, some economists say.

“Negative expectations had gone really far,” said Alberto Gallo, senior credit strategist at RBS Global Banking & Markets in London. Some in the market had been expecting Italian yields to top 8% before buyers would step in, he said.

Domestic investors have been active buyers of Italian debt for more than a decade, and with yields at such high levels, they likely contributed to the strong demand at Tuesday’s auctions, analysts said.

“Italy’s primary balance is strong and its people save, and that’s one of its strengths,” said Mr. Gallo. “Still, by itself, that’s not enough to bring the country out of debt.”

Italian banks also have an incentive to buy the country’s debt, because high yields can boost their net interest margins. The downside is that by adding to already-big holdings of government debt, the link between the banks and the risk of sovereign default becomes even greater.

That Italy had to offer higher yields on shorter-dated bonds at Tuesday’s sale underscores that investors want to be compensated for the risk attached to the country’s near-term fiscal outlook.

“Italy does not have the ability to push down its funding costs to sustainable levels,” said Jeffrey Sica, president and chief investment officer of SICA Wealth Management, which has more than $1 billion in client assets, real estate and private-equity holdings.

Non-European investors have been big sellers of Italian and Spanish debt in recent weeks. If that selling continues, the entire euro-zone debt market could seize up, analysts warn. Unless euro-zone leaders come up with a solution to the currency union’s financial and fiscal woes, foreign investors could offload more than €1 trillion of euro-zone bonds in the coming months, Japan’s Nomura warned in a research note.

Italy and Spain, in particular, could face a funding crunch early next year when they will need to refinance a large amount of their debt.

“The funding costs in Italy and Spain are already at really high levels, and if these costs surge again during the February-to-April period, you can basically say Italy and Spain will be near the bankruptcy point,” said Janet Kong, a former International Monetary Fund economist who is now a managing director at China International Capital Corp.

Italy alone is expected to raise around €220 billion in the bond market in 2012, according to analyst estimates.

“The sheer size of Italy’s economy and bond market has taken the crisis to a whole new level and has been a key factor in the reassessment of the risks of a breakup of the bloc,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy, a consultancy specializing in sovereign credit risk. “Never before has the threat of an Italian default been more real.”