Spain debt costs set to leap as risk aversion grows

By Paul Day

MADRID, April 17 (Reuters) - Spain will see its borrowing costs leap when it sells short-term debt on Tuesday, a day after investor concern over its deficit and banking sector pushed longer term risk premiums above 6 percent, threatening a new crisis in the euro zone.

The auction of 12- and 18-month Treasury bills will test market nervousness, which has spread to Italy, before a more challenging sale on Thursday of 2-year and 10-year bonds.

Yields on the latter climbed over 6.1 percent on the secondary market on Monday, a five-month high, as investors fled to safe-haven German Bunds, where yields were at their lowest since 2008 when the euro zone debt crisis was at its height. Debt costs beyond 7 percent are seen as unsustainable.

Madrid, which has completed almost half its debt issuance plans this year, aims to raise between 2 billion and 3 billion euros ($2.62 billion-$3.92 billion) on Tuesday and between 1.5 billion and 2.5 billion euros from bonds maturing in 2014 and 2022 on Thursday.

"Yields are going to rise very sharply from last time, there's no doubt about it," strategist at Monument Securities Marc Ostwald said.

On Monday, 12-month T-bill yields on the secondary market stood at around 2.7 percent, a guide to the outcome of the primary auction, compared to an average yield of 1.418 percent last month. The 18-month bill previously sold at auction for 1.711 percent but traded at over 3 percent on Monday. The results of Tuesday's auction will be released at about 0840 GMT.

"Bills are basically an overdraft facility for the government with the banks, so this tells us how much distress there is in the banking sector," Ostwald said.

"Thursday is more about demand for Spanish debt and the picture of an ever decreasing circle seen in Greece and Portugal and apparently in Spain too."

The Spanish government and European leaders have vehemently denied that mounting debt problems might force Spain to seek an international bailout like Greece, Portugal and Ireland but analysts see market nerves continuing.

Spain's banks, virtually closed off from international wholesale debt markets by investors spooked by the uncertainty surrounding property values on their books, have used cheap loans from the European Central Bank to buy domestic paper.

Spanish sovereign debt in the hands of its banks has jumped to 231 billion euros in February from 165 billion euros last November, while the banks borrowed a record 316 billion euros from the ECB in March, according to Bank of Spain data.

"The figures alerted the markets to the fragility of the Spanish banking system ... The nervousness you're seeing in the 10-year bond yield going in to this week's auction for example is going to stay around for while yet," Capital Economics European economist Mark Miller said.

At the end of February, non-residents held 42 percent of Spanish public debt, the lowest level since 2007 and down from 50 percent in December, Treasury figures show.

Spain's banks have been told to raise 52 billion euros as part of the sector's latest round of consolidation, but with private investors and the government loathe to put money in, they may be forced to apply for aid, some analysts say.

RISING PREMIUMS

The premium investors demand to hold Spanish over German debt has jumped since Prime Minister Mariano Rajoy unilaterally eased 2012's deficit target in March, on worries he will struggle to restart growth while pushing austerity measures.

A government source said Spain might intervene in regional finances in return for financing help as soon as next month if they do not meet their targets and the government acknowledged it had probably tipped into its second recession since 2009.

The Treasury has already met 47 percent of its gross issuance bond target this year, though has mostly concentrated on paper with maturities of less than 10 years to make the most of the ECB's long-term refinancing operations (LTRO) credit line, extended to avert a new euro zone credit crunch.

"Given the relatively weak auction of April 4, all eyes will be on the extent of domestic appetite and the strength of the LTRO bid," interest rate strategist at Citi Peter Goves said.

Spain sold 2.6 billion euros of debt, at the low end of its target range, on April 4, with a bond maturing in 2020 yielding an average 5.338 percent, higher than a forecast 5.2 percent.

Thursday's benchmark bond, maturing Jan. 31, 2022, with a 5.85 percent coupon, was last sold via syndicate in February at a yield of 5.403 percent and before that was sold at a primary auction on Nov. 17 for an average yield of 6.975 percent.

The shorter-termed bond, maturing Oct. 31, 2014, with a 3.3 percent coupon, was trading at about 3.65 percent on Monday compared to 3.495 percent last October. ($1 = 0.7644 euros)