* 2010 euro zone debt issuance could be up 225 bln euros
* Sovereigns to favour bond issuance over T-bills
* High-yielders to pre-fund 2010 to avoid yield challenge
By George Matlock
LONDON, Aug 20 (Reuters) - Record euro zone government borrowing this year will be surpassed in 2010 despite growing economic optimism, as issuers rebalance portfolios away from Treasury bills and face ongoing, recession-busting expenditure.
Some analysts say gross government bond issuance next year could be as much as 225 billion euros ($317 billion) up on 2009.
Governments will want to issue fewer short-term bills while they can lock in longer-term funds at low rates before an anticipated rise in yields, thereby putting off inevitable tax increases that might choke off a fledgling economic recovery.
Sovereigns with the highest borrowing costs in the euro zone like Greece and Ireland may also want to pre-fund 2010 while yields are lower.
Even if the premium for these funds over benchmark German Bund yields diminishes as the economic landscape brightens, it may not fully compensate for a general rise in absolute yields in a recovering economy.
Last week, the two largest euro zone economies, Germany and France, reported a surprise increase in gross domestic product. Improving economies after the two-year global credit crisis mean higher tax receipts and a chance to rely less on borrowing funds by issuing bonds.
Sensing recovery, equities have rallied since March and posted index levels last seen in November when the global credit crisis was entering its darkest phase.
But economists reckon that as recession fades, the invoice for the largest-ever peacetime debt issuance will be mostly still unpaid and economies too fragile for tax rate hikes.
"If stage one of global turmoil was the banking and financial crisis and stage two was the economic crisis, the current phase -- stage three -- can be described as an ongoing crisis in public finances," said Kristin Lindow, senior vice president at ratings agency Moody's Investors Service.
"Governments have leveraged up their balance sheets to compensate for private sector deleveraging."
Lindow said intervention could be necessary until household and bank balance sheets are made healthy again, even as exit strategies to unwind such interventions are also beginning to be discussed publicly.
As some countries are saddled with double-digit percentage ratios of public deficits to gross domestic product, this will need to be funded by issuing more debt, keeping debt yields high.
ECONOMY BRIGHTENS, DEBT LOOKS THE OTHER WAY
In time, the tax-and-borrow mix may return more in favour of taxation. That will help bond markets which are weary from the vast debt issuance this year. But that remix will not happen quickly and investors may be shy of buying higher-yielding bonds from the most-indebted nations such as Italy, Greece or Ireland.
Commerzbank expects euro zone bond sales in 2010 to be 1.1 trillion euros, compared with 875 billion in 2009, and for governments to shield taxpayers from rising debt servicing costs by issuing bonds rather than refinancing short-maturity bills, while locking in investors for a longer period of time.
"This may be warranted to lock in attractive funding levels from an issuer's perspective as short-end rates are poised to rise faster than long-end yields, so the 2/10 year curve is set to flatten bearishly. We expect 2/10 spread to contract to some 155 basis points in Q3 2010 with 10-year Bund yields climbing towards 3.80 percent from 3.30 percent," said David Schnautz, bond analyst at Commerzbank.
Economists reckon the 2-10-year yield curve will flatten to 170 basis points by end-2009 from a euro lifetime wide of 225 bps recently.
With the flattening yield curve and generally rising bond yields, the cost of borrowing by governments will rise -- at precisely the time when economists are forecasting more bond issuance.
Schnautz said tightening high-yielder spreads over euro zone benchmark German Bunds will be less than the general rise in debt yields, punishing exchequers -- a view shared by others.
"The (Italian-German) yield spread should not return to the pre-crisis level of circa 20/30 basis points seen in June 2007 in the coming months, as the repricing of credit risk due to the financial crisis will make investors more careful in evaluating fundamentals," said Giuseppe Maraffino, a bond strategist at UniCredit in Milan.
TAP DANCING FROM BILLS TO BONDS
Redemption of maturing bonds will be lower in 2010 than this year and economists are not expecting fresh rescue packages to support industries. But they expect issuers to tap the market with more bonds.
That is because sovereigns will move away from heavy reliance this year on near-cash Treasury bill issuance.
"The average maturity of bonds issued by governments will increase. Since last October governments have been issuing mainly at short maturities," said Maraffino.
"Now the situation is becoming different, in the sense that risk aversion has eased and gradually we are discarding uncertainty. It is true that the economy is still contracting but we know that it has already bottomed out," he added.
Maraffino said he expected the euro zone economy to return to potential growth in 2011 and issuers will also want to avoid the bulk of their debt falling due for redemption over the next year while tax receipts remain subdued.
UniCredit's view is that net T-bill issuance will be 150 billion euros in 2010, slightly down from this year. But it sees bond issuance rising by around 50 billion euros so that bond sales total 900 billion euros.
The flattening of the 2/10 year yield curve will be confirmed if sovereigns move from shortest-dated money market instruments towards short-dated bonds in their debt portfolios. (Editing by Stephen Nisbet)