LONDON: Spanish government bond yields held near euro-era highs on Tuesday as the country faced a tricky test at a short-term debt sale with funding costs at levels seen as unsustainable and many analysts saying a sovereign bailout is inevitable.
Safe-haven German bonds held steady after rallying on Monday when relief over Greek election results gave way to concerns over Spain's deteriorating economic and fiscal health.
Spanish 10-year yields shot above 7 percent on Monday to their highest levels in euro-era history on concerns that the country's banking bailout would need to become a sovereign bailout sooner rather than later.
They were last flat on the day at 7.19 percent, after rising nearly 30 basis points on Monday.
"Spain can carry on for a short period of time, maybe 2 or 3 months as they can issue at the short end of the curve where funding costs are still more in line with historic levels," said Michael Leister, DZ Bank rate strategist.
"But given how much is at stake and pressure from the Troika... we think they could take the decision somewhat quicker than we saw with Greece, Ireland or Portugal who tried to stretch it to the limit."
Madrid will get a taste of market sentiment towards its debt at a sale of 12- and 18-month bills on Tuesday, at which it is set to pay record prices to borrow.
"We're going to be watching Spain basically," a trader said. "The auctions will go OK, the dealers will see to that, but that's no indication there's any underlying demand."
Primary markets dealers are obligated to absorb new issuance but are increasingly cheapening prices in the secondary market ahead of auctions.
Spain will attempt to sell up 2 billion euros of bonds with maturities up to five years on Thursday - a relatively small target size.
At a Group of 20 summit, European leaders agreed to move towards a more integrated banking system to stem the debt crisis which has seen domestic banks increasingly entwined with their indebted sovereigns.
"The market knows that a complete solution is unlikely at this stage but will be sensitive to signs that there is a strong commitment by the stakeholders in the Euro project," said Richard Bell, senior partner and co-CIO at Rogge Global Partners, which manages $51 billion of assets.
"The recent Spain (bank) bailout was a clear attempt to get ahead of the curve, but we are still very cautious. Progress towards fiscal union is likely to remain painfully slow and there is a clear risk of market disappointment."
Italian bonds have fared better than their Spanish counterparts in recent weeks, despite the risk of contagion should Spain be forced into a bailout.
The 10-year spread between Italian and Spanish yields has widened around 70 basis points in the last week and a half to 113 basis points and ING expect it eventually to hit 150 bps.
The deteriorating euro zone crisis is expected to be reflected in a sharp drop in German investor sentiment when the ZEW survey is released at 0900 GMT.
An even worse than expected number should help Bunds extend recent gains, the trader said.
"Bund positions look a lot cleaner now after a lot of the longs were cleared out during last week's sell-off."
September Bund futures were five ticks higher at 142.69, with 10-year yields up 0.6 bps at 1.417 percent.
Greece's conservatives said they were poised to form a coalition government with the Socialists, easing fears that the country would leave the euro. Key now for markets will be whether the country seeks to renegotiate its bailout deal.
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