LONDON (Reuters) - A "disastrous" sale of German benchmark bonds on Wednesday sparked fears the debt crisis was beginning to threaten even Europe's biggest economy, with the Bundesbank forced to hold on to record amounts to ensure the auction did not fail.
In one of the least successful debt sales by Europe's powerhouse economy since the launch of the single currency, the low returns offered -- just 2 percent annually over 10 years -- deterred investors made uneasy by the escalating cost of the crisis to Germany.
That meant the central bank had to pick up 39 percent of the 6 billion euros of debt Germany had hoped to sell after commercial banks bought just 3.644 billion euros of the issue.
"It is a complete and utter disaster," said Marc Ostwald, strategist at Monument Securities in London.
"This does not bode well. It is the worst of the uncovered auctions that we've had this year and little wonder that the Bund sold off on the back of it."
Banks bid for far less at the sale than the debt agency's target, meaning the auction was technically 'uncovered'. Uncovered auctions are not uncommon for Germany, but the scale of the Bundesbank retention was exceptional.
The head of the country's debt agency said extremely nervous market sentiment, not falling investor demand, was responsible for the poor sale result. He added that the retained bonds would be sold on the secondary market and that the three remaining German auctions planned for 2011 would go ahead.
Bund futures, the euro and European stocks fell after the auction, with Germany's 10-year debt costs rising above equivalent U.S. yields for the first time since early October.
For a graphic on German 10-year bond yields minus inflation, click on link.reuters.com/daw25s
The results compared with an average retention rate by the Bundesbank of 17.83 percent at 10-year bond auctions in 2011. Data from IFR, a Thomson Reuters service, showed this to be the highest Bundesbank retention since at least July 1999.
German yields have been forced down to record lows by demand from investors seeking shelter from the debt crisis that has ensnared Italy and Spain and now threatens to drag down other, higher-rated countries such as France and Belgium.
The new bond promised to pay out a 2.0 percent interest rate -- the lowest ever on an issue of German 10-year Bunds. The average yield at the auction was 1.98 percent, down from 2.09 percent at the last sale of the previous benchmark in October.
The weak auction demonstrates that some are now beginning to think twice about whether such low yields are appealing given the threat that Germany will have to begin diluting its credibility by underwriting the debt of the euro zone's struggling states.
"Bunds are starting to lose their appeal because markets have to believe the euro bonds story and Germany is very close to starting, essentially, to guarantee the debt of other countries," said Achilleas Georgolopoulos, strategist at Lloyds Bank in London.
Highlighting that the move away from German debt has been happening for some time, foreigners' net buying of German Bunds in the third quarter of 2011 fell to 9 billion euros from over 30 billion euros, according to balance of payments data from the Bundesbank.
"What we are doing is not getting involved in any of the periphery or core countries apart from Bunds, but even in Bunds we are finding it more difficult," said Sanjay Joshi, head of fixed income at London & Capital, which has around $3.5 billion in assets under management.
"I do get worried about Germany and the political inactivity that is coming from there."
A possible path toward a common euro zone bond -- which Germany opposes as it would raise the country's cost of borrowing -- is being laid out by the European Commission, which has unveiled proposals for tighter budget controls over euro zone countries' budgets.
Additional reporting by Kirsten Donovan and Marius Zaharia; Graphic by Scott Barber; Editing by Catherine Evans