2012.05.28 13:51:36 UPDATE: Spanish Bonds Slump On Bankia Bailout Fears

--Spanish yield spreads against German bunds hit all-time highs --Debt insurance costs also reach record levels --Concerns grow over government's reliance on domestic banks for funding (Adds CDS levels, analyst comment, updates prices.) By Tommy Stubbington Of DOW JONES NEWSWIRES LONDON (Dow Jones)--Spanish sovereign bonds came under heavy pressure Monday, pushing yield spreads against German bunds and debt insurance costs to record highs, after the government announced a EUR19 billion bailout of Bankia. The announcement late Friday effectively nationalizing Bankia raised concern the government may be on the hook for further funds to prop up its fragile banking sector. Bankia is Spain's third-largest lender by assets, and public finances are already precarious. Spanish 10-year bond yields climbed 18 basis points to 6.47%, its highest in 2012, before easing back to 6.43%, according to Tradeweb. The yield spread against 10-year bunds widened to more than 500 basis points, a record high. The cost of buying protection against a Spanish default pushed to a fresh record, with five-year credit default swaps on Spain widening 10 basis points to 557 basis points, four basis points wider than the previous record close reached May 21, according to data-provider Markit. Credit default swaps are derivatives that function like an insurance contract for debt. If a borrower defaults, sellers compensate buyers. With foreign Spanish government bonds increasingly in domestic hands, market participants are concerned about the ever closer relationship between the government, which is fighting to bring its budget deficit under control, and the banking system. Data from the Spanish Central Bank Monday showed holdings of Spanish government bonds by non-residents dropped to 48.8% of the total last year from 53.4% in 2010. That figure is set to fall further following the European Central Bank's two long-term refinancing operations in December and February, which fueled domestic demand for Spanish sovereign debt. Spanish yields are likely to continue to rise, with the government and the banks locked in a "feedback loop", said Richard McGuire, an interest rate strategist at Rabobank International. "The process is self-fulfilling. The more [sovereign] yields rise the more denuded banks' balance sheets become. This in turn fuels concerns about the banking system which further inflames yields," McGuire said. It will take a "circuit-breaker" from outside Spain, such as intervention in bond markets by the ECB, to arrest the rise in yields, according to McGuire. Shares in Bankia re-opened Monday following Friday's rescue plan and fell by more than 20%. Markets had begun the day relatively upbeat after polls showed growing support for pro-bailout parties ahead of next month's Greek election. But the tone soon reversed as investors sold Spanish bonds, with Italy also caught in the crossfire, seeing its 10-year yields rise four basis points to 5.84% and shorter-dated yields rise more sharply. In relatively thin trading, with a holiday in much of Europe, German bunds recouped early losses to trade unchanged on the day. "The Spanish government's plans for Bankia are worrying," said Simon Penn, a markets analyst at UBS, referring to reports that the government plans to "recapitalize" the lender with Spanish government bonds, which can then be used as collateral to borrow funds at the European Central Bank. That could worsen the bank's health by increasing its exposure to Spanish sovereign debt, Penn said. -By Tommy Stubbington, Dow Jones Newswires, +44 20 7842 9268; tommy.stubbington@dowjones.com (Ben Edwards in London and David Roman in Madrid contributed to this article.) (END) Dow Jones Newswires May 28, 2012 07:51 ET (11:51 GMT)