By Valentina Za and Francesca Landini
MILAN (Reuters) - Italy bought back on Wednesday more than 1 billion euros of bonds whose value had tumbled after a sovereign downgrade forced some holders to sell, easing pressure on investors whose support it needs to stay afloat in the worsening euro zone debt crisis.
A two-notch cut in Italy's sovereign rating by Moody's this month will force Italian inflation-linked bonds out of the flagship Barclays investment indices at the end of July, leading some funds to sell their holdings.
The bonds, which pay a return linked to euro zone inflation, have sold off sharply since the downgrade, underperforming even Italy's regular bonds, yields on which are flirting with levels seen as problematic as fears rise that it may eventually need an international bailout.
On Wednesday, the Treasury bought back inflation-linked bonds due in 2017, 2019, 2023 and 2035, for an overall amount of 1.326 billion euros. The four bonds were those with a relatively high weighting in indices and the largest outstanding amounts. In exchange, it sold 1.16 billion euros of a May 1, 2017 fixed-rate bond at an average price of 94.716.
"It was an act of courtesy towards those who hold Italian linkers, though the downgrade and the index drop didn't come as a surprise and I don't think people are waiting until the end of the month to sell," an Italian bond trader said.
"The decision not to sell linkers tomorrow doesn't surprise me either, they've always kept a margin of flexibility there."
The Treasury said late on Tuesday it would not sell inflation-linked paper at Thursday's auction, as it would normally have done when offering zero-coupon bonds.
The trader said he would expect the Treasury not to sell any more inflation-linked debt in the near future, although the maturing in September of an 11.7 billion euro linker might fuel demand. Italy's Treasury is also due to launch another inflation-linked bond for small investors by year-end after two successful sales earlier this year.
Analysts at UniCredit expected Wednesday's exchange auction and the Treasury's decision not to offer linkers but only zero-coupon paper on Thursday to provide some relief for bondholders.
"The exchange auction will give investors the opportunity to sell inflation-linked bonds without having to deal with the relatively low liquidity this market currently has," UniCredit said in a note.
The yield on Italy's September 2021 inflation-linked bond was 5.67 percent on Wednesday, having risen 84 basis points from 4.83 percent the day before the July 13 downgrade. That compares with a 59 basis point rise in the yield of the September 2021 nominal bond over the same period, to 6.31 percent.
Italy will offer 8.5 billion euros of six-month bills on Friday but the real market test comes on Monday with a sale of five- and 10-year debt. Details are expected later on Wednesday.
The Treasury announced earlier this month that it would not hold its mid-August bond auction, in line with practice seen in recent years given poor market liquidity at the height of the summer holiday season. It has said repeatedly that all other auctions will be held as usual.
Italian 10-year yields have risen to 6.5 percent, following Spain's borrowing costs higher as the prospect of a possible bailout for Madrid unnerves investors.
Market concerns about the euro zone debt crisis have been exacerbated by European Union officials saying on Tuesday that Greece has little hope of meeting the terms of its bailouts.
Burdened with a 2 trillion euro debt pile and in the grip of a harsh recession, Italy is vulnerable to the deteriorating climate while joint EU action to stem the crisis has stalled.
(Editing by Catherine Evans)