LONDON, April 27 German government bonds rallied early on Friday as demand for low-risk assets increased after Standard and Poor's cut Spain's credit rating, ramping up worries about debt from the euro zone's struggling southern members ahead of an Italian bond auction.
The Bund future rose 34 ticks to 141.26, closing in on a record high of 141.37 set at the start of the week. Demand was expected to remain strong into the weekend as sentiment sours against the region's weaker states.
"People have seen this coming but I expect there will still be a bit of a panic bid... this has got to be good for Bunds," a London-based bond trader said.
Spain's credit rating was cut by two notches to BBB-plus, with S&P citing the expected deterioration of government finances.
The blow to already-fragile investor sentiment comes ahead of an Italian auction of 6.25 billion euros of government bonds and was likely to add to the upward pressure on yields already anticipated due to the sale.
While the auction was still expected to see bidders turn up, borrowing costs were expected to be higher than at previous sales, reflecting the weakness in secondary markets over the past month.
Analysts said the movements in prices before and after the auction would be the best gauge of whether long-term investors, who typically hold bonds to maturity and are a key source of funds for highly-indebted countries, were willing to back Italy.