Spanish and Italian bond yields May 14, 2012

Spanish and Italian bond yields May 14, 2012 : (Reuters) - Spanish and Italian bond yields and default insurance costs surged on Monday as investors worried about a potential Greek exit from the euro zone and Spain's ailing banks dumped riskier assets, propelling safe-haven German yields to record lows.

The euro fell near four-month lows and global equities slumped after a major Greek leftist party refused to join a unity government, taking Athens closer to the brink of bankruptcy and a possible exit from the euro bloc

German Bund futures rose as much as 92 ticks on the day to an all time high of 143.69 while Germany 10-year yields plumbed a record low of 1.434 percent. With capital preservation paramount in investors' minds, German yields look set to push to uncharted territory in coming days.

Greece's political impasse, the bad debts plaguing Spanish banks and further signs of the euro zone heading into recession all heightened investor fears that the region is lurching deeper into crisis, hiking Spanish and Italian borrowing costs at debt auctions.

The cost of insuring against a Spanish default hit a record high while Spanish 10-year yields jumped 30 basis points to 6.33 percent, kicking its benchmark premium over German debt to euro-era highs.

Beyond 6 percent, Spain's borrowing costs could accelerate towards unaffordable levels as happened in Ireland and Portugal, raising expectations that the European Central Bank will revive its bond buying programme.

"There's a real risk for the market that at some point Greece will have to leave the euro if they don't find political cohesion ... This will add to the contagion in the market and the countries that will suffer more are Spain and Italy," ING strategist Alessandro Giansanti said.

"If Spanish yields go above 6.5 percent the ECB will have to calm the market to try and cap the level of yields because we don't want to go into a situation where Spain's yields are sky-rocketing to 7 percent."

Spain and Italy remain at the forefront of the crisis and bond auctions this week are straining investor nerves.

Investors worry that sovereign debt demand from Spanish banks which has helped the country meet almost half its 2012 funding needs could be torpedoed as the sector comes under pressure to clean up toxic real estate loans.

Spain sold 2.9 billion euros of 12- and 18-month bills, with the one-year yields rising to 2.985 percent, almost a percentage point above 30-year German yields in the secondary market.

It faces a tougher test on Thursday when it may need to drum up more domestic support to sell 3- and 4-year bonds as its fiscal and bank problems deter foreign buyers.

CONTAGION

Italy, whose yields rose 22 bps to 5.90 percent, paid its highest three-year borrowing costs since January at a sale of bonds earlier.

While the Treasury issued at the top of a planned range of 3.50-5.25 billion euros for the four maturities auctioned, its high debt pile makes it vulnerable to contagion from Spain.

"The auction is OK but I still think things are going to get worse rather than better in the short term," said Alan McQuaid, chief economist at Bloxham Stockbrokers in Dublin.

"Given the overall backdrop, they'll be happy with it but the overall trend is of higher rather than lower yields."

German bond yields were at record lows across the curve, with 30-year bond yields falling at a faster pace than two-year yields, as investors looked further up the curve for some return on their capital as short term yields near zero.

Adding to safe-haven demand, German Chancellor Angela Merkel's conservatives suffered a crushing defeat on Sunday in an election in Germany's most populous state. This could embolden the opposition to step up attacks on her European austerity policies.

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