Spanish bonds battered, bank bailout raises concerns

LONDON (Reuters) - Spanish bond yields rose on Monday as a bailout of up to 100 billion euros for the country's struggling banks failed to quell concerns that Madrid may end up locked out of funding markets and forced to seek external help.

After weeks of growing speculation and rising nervousness in the financial markets, euro zone finance ministers agreed at the weekend to lend Madrid up to 100 billion euros ($125 billion) for its bank rescue fund.

An early rally in Spanish debt quickly petered out, and 10-year bond yields ended the day 25 basis points higher at 6.5 percent - on course for their worst day since early April and within 30 basis points of euro-era highs.

"I don't think we're going to get any more positive news out, so the brief rally we had this morning seems to have been it," said Grant Lewis, head of research at Daiwa Capital Markets in London.

German Bund futures rebounded to 143.97, up 44 ticks on the day, having sunk to a low of 142.48 in early trade.

Concerns centered around Spain's ability to keep tapping bond markets if the bailout cash adds to the country's outstanding debt, subordinates existing bondholders or leads to further credit ratings downgrades.

"(Downgrades) would make their return to capital markets all the more difficult ... I think that would be the final nail in the coffin terms of avoiding a wider bailout," Lewis said.

The country still has 37 billion euros to raise on the capital markets this year and made a strong start to fundraising in the first quarter, but rising borrowing costs have since seen the pace of its bond sales slow to a crawl.

"We thought the tightening would last a bit longer but that wasn't the case. Spanish yields are heading towards the highs we saw at the beginning of June and this shows how difficult the situation is," said Viola Julien, a strategist at Helaba Landesbank hesse-Thueringen.

"Accepting aid for recapitalization of the banking sector means it will have to finance itself on capital markets for its deficit and it's getting harder with yields climbing."

No precise bailout figure was set after Spain said it would await an independent assessment of the capital needs of its banking sector, due to be delivered in less than two weeks.

The Spanish rescue follows full-blown bailouts for Greece, Ireland and Portugal since 2010.

MAKE-OR-BREAK GREEK VOTE

Although Monday's focus was firmly on Spain, Greece's upcoming election and bond auctions in Italy are likely to dominate trading in the coming days and both should benefit German Bunds, traders said.

A June 17 election could propel Greece out of the euro zone - with unknown consequences for the rest of the bloc - if parties opposed to the terms of the country's international bailout win power.

"I think the market's complacent on Greece. We think Greek exit risk kicks in about two weeks after the elections, even if it's a hung parliament," a trader said.

Italian yields also reversed earlier falls to rise to 6.04 percent, almost 21 bps up on the day as investors turned their focus to a bond auction on Thursday that could prove challenging in the risk-off environment.

(Editing by Catherine Evans)