LONDON: German government bond yields hit record lows on Friday and were expected to fall further as a mass downgrade by Moody's of Spanish banks' credit heightened fears that a Greek political crisis could evolve into a euro zone financial meltdown.
Investor appetite for the least risky assets showed no sign of flagging, despite the ever lower returns on offer, as they fretted about contagion from Greece to Spain, whose banks have
been hammered by a property bust.
With markets ignoring a poll showing the tide may be turning in favour of the pro-bailout parties in Greece a month before a snap election, Italian and Spanish bond yield curves flattened - a symptom of a higher perceived default risk.
"Polls can obviously change. Obviously we know how shaky the situation is and this is not really taken very seriously," said Commerzbank rate strategist David Schnautz.
"Moody's continues to wield the axe on the banking sector and that's more of a hard fact than any polls. It's another day and another high for the Bund futures and I don't see anything stopping them on the way up."
Bund futures were last 10 ticks higher at 143.77, having hit a record high of 144.06 earlier in the session. Schnautz recommended investors target 145.50, which was consistent with another 10 basis point fall in cash 10-year yields towards 1.30 percent.
He also said two-year German yields, which hit a record low of 2.8 bps, could soon fall into negative territory as investors were more concerned about getting most of their money back rather than making a profit.
Some other analysts were reluctant to bet more on Bunds.
"There's a catch here," said Athanasios Ladopoulos, partner and senior fund manager at Swiss Investment Managers, a hedge fund.
"If these are short positions, fine. But if you get a scenario of a violent break-up of the euro ... then Germany finds itself with a lot of collateral of low-to-zero value and that would hit German banks and Bunds as well."
Noting a similar risk, Societe Generale strategists recommended investors to pick top-rated UK gilts and US Treasuries as safe havens, as they also offer a 30-40 basis points premium over Bunds.
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For now, contagion has mainly been hitting debt issued by Spain and Italy.
Their 10-year yields fell on Friday driven by rumours of a ban on naked short-selling of Spanish banking stocks, but remained close to or above 6 percent and were seen heading towards levels considered unsustainable.
Wide swings are a common sight as their bond markets are also becoming gradually less liquid.
The difference between the price that buyers want to pay for a 10-year Spanish bond and what sellers want to receive, a gauge of market liquidity, was about 75 cents on Friday, almost double what it was in March when the government first said its budget deficit cutting efforts were off track.
"Volumes are light - just bits and pieces on the screens," one trader said. "If they (Greece) end up exiting the euro ... there's a can of worms to be opened and it can become very messy and people don't want to be too involved."
Short-term bonds underperformed. The Spanish 2/10-year yield spread has narrowed by 50 bps this month to about 200 bps. The Italian curve flattened at a similar pace, to 220 bps.
"This is still a healthy shape of the curve, but the flattening move is reminding people of what we've seen in November," Commerzbank's Schnautz said, adding that those spreads could "easily narrow" by 25 bps a day.
Italian and Spanish yields hit record highs in a previous wave of the sovereign crisis in November, before the European Central Bank pumped almost 1 trillion euros of three-year loans into the banking system.
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