* Spanish yields jump before next week's auction, after bank data * Spanish yield curve has flattened sharply since mid-March * The cost of insuring Spain against default hits record high * German 10-yr yields at record lows on flight to quality By Emelia Sithole-Matarise and Ana Nicolaci da Costa LONDON, April 13 (Reuters) - Spain's government bond yields rose and the cost of insuring its debt hit an all-time high on Friday as record borrowing by its banks from the ECB highlighted fears about the country's finances before it tests market appetite for its debt next week. The Spanish Treasury plans to sell two- and 10-year bonds at Thursday's auction. Some strategists said yields for the longer-term maturity could break back through 6 percent and accelerate a rise in borrowing costs to unsustainable levels. Recent auctions have seen Italy's cost of borrowing over one and three years rise, while Spain also paid more to borrow at auctions last week. "The market is getting a little bit concerned it could be difficult in this kind of market environment to sell a 10-year bond and if we get another bad auction for Spain, as we did last week, we can easily see another bout of (spread) widening," said Gianluca Ziglio, a strategist at UBS. Spanish 10-year government bond yields jumped 18 basis points to 5.99 percent, taking their yield spread over German benchmarks to 435 bps - just 34 bps shy of their widest level in the euro era, hit in November. The five-year yield was up 11 bps at 4.92 percent while the cost of insuring Spanish debt against default for five years closed above 500 basis points for the first time, according to provider Markit. That means it costs $504,000 annually to buy $10 million of protection against a Spanish default using a five-year credit default swap (CDS) contract. Spanish 10-year yields tested the 6 percent psychological hurdle earlier in the week as concerns rise that its crippled banks and shrinking economy could make it the next source of contagion in the euro zone. Italian yields were dragged higher with their Spanish counterparts, rising 13 bps to 5.54 percent. The cost of Italian CDS rose 15 bps to 433 bps. "What is clear is that this benign environment has come to an end. It's not that easy any more for the financing agencies in Spain and Italy to sell their paper," Leister said. "Overall the LTRO (the ECB's long-term refinancing operation) effect is fading and the market is back to fundamentals." The European Central Bank extended 1 trillion euros of ultra-cheap three-year loans to banks in LTRO operations in December and February, a cash injection that helped bring down yields on bonds of the euro zone's most indebted sovereigns. Data on Friday showed Spanish banks borrowed a record 316.3 billion euros from the ECB in March, almost double the previous month's total, as they remained virtually excluded from wholesale credit markets. There are growing concerns the banks could be vulnerable to a blow-out in Spanish debt after they used their cheap ECB loans to buy the country's bonds in a carry trade. "The situation in general from a fundamental perspective is deteriorating," said Ziglio. "Market demand is contracting, a lot of investors don't want to get involved anymore in this kind of paper. "On top of that, you got a lot of buying from domestic banks that has made these banks even more vulnerable to any further widening in sovereign spreads." CURVE-FLATTENING The spread between 10- and five-year Spanish bond yields has narrowed more than 40 basis points since the middle of March - a curve-flattening trend analysts say is worrying and reflects the greater default risk attached to holding Spanish debt. The last time the spread narrowed as sharply was at the height of the stress in euro zone bond markets in November. The pressure on peripheral euro zone zone bonds spurred a flight to quality, pushing German 10-year yields to record lows of 1.636 percent. German Bund futures jumped 69 ticks on the day to settle at 140.36 as worries about Chinese growth also boosted safer assets and knocked riskier investments such as stocks. .