LONDON Spanish government bond yields rose above 7 percent on Thursday after Moody's cut the Spain's credit rating to just one notch above "junk", pushing borrowing costs ever higher and raising the prospect of a full-scale bailout.
Moody's slashed Spain three notches to Baa3, its lowest investment grade rating, and said it could lower the rating further within the next three months. It said the newly approved euro zone plan to help Spanish banks would increase the country's debt burden.
Yields on Spain's 10-year bonds rose as much as 25 basis points to a euro-era high of 7.02 percent, a financing level seen as unsustainable in the long term. Shorter-dated paper was also under pressure with two-year yields rising a similar amount to around 5.20 percent.
"The ratings cut is more bad news for Spain and it increases the chance of a full bailout going forward," a trader said.
Euro zone finance ministers agreed on Saturday to lend Spain up to 100 billion euros ($125.74 billion) to shore up its banks, a move that did little to reassure markets.
If Spain were cut to junk, some index-tracking investors would be forced to sell its bonds, adding to upwards pressure on yields and pushing funding costs higher.
Greece, Ireland and Portugal were quickly forced to ask for a bailout after yields on their bonds rose above 7 percent.
"Spain is teetering on the edge of investment grade status and the risk in the near term is that investors begin to trade the risk they are cut to speculative grade," ING's head of investment grade strategy, Padhraic Garvey, said.
"And if they do get cut further then you'll get another wave of selling."
Spanish banks were large buyers of their sovereign's debt earlier this year, absorbing bonds sold by international investors, but with the banks under increasing pressure it is unclear how much capacity they have to shore up the government in the future.
"If there's no reaction from Europe, it's a likely path (that yields will continue to rise)," said Peter Schaffrik, head of European rates strategy at RBC Capital Markets.
"One of the only things we see that can change the situation on a lasting basis is some form of debt mutualisation which the Germans are reluctant to do."
Spain is due to borrow in the bond market next Thursday. Details of the bonds to be sold will be announced on Friday.
ITALY PASSES AUCTION TEST
Italy tested sentiment for its debt with a sale of 4.5 billion euros of bonds, finding better-than-expected demand although borrowing costs rose sharply.
"These auctions will be judged a success in the short term, but the trend in yields and spreads is something which requires something from the policymaker level to reverse," said Credit Agricole rate strategist Peter Chatwell.
Technocrat Prime Minister Mario Monti - whose approval rating has slumped - appealed to Italy's politicians on Wednesday to back his tough economic medicine to avoid Rome becoming the next victim of the euro debt crisis.
But some analysts said time was running out.
"We are fast approaching the point where both Spain and Italy may have to be removed from the market," said Gary Jenkins, director of Swordfish Research.
Dealers - who are obliged to absorb new issuance - had cheapened the paper considerably before the auction but Italian bonds remained under pressure after the sale. Ten-year yields were 9 bps higher at 6.30 percent.
German Bund futures gave up some early gains and were last 8 ticks higher at 141.79, gaining little momentum from the negative sentiment towards peripheral issuers. German 10-year yields were half a basis point higher at 1.50 percent.
Longer-dated paper underperformed, with 30-year yields up 6 bps as traders cited further selling related to changes in Danish pension fund rules.
"There's not a huge amount of natural flow in the long end of the curve so it tends to all go one way or another," a second trader said. "We could see this trend play out for a while yet."
(Editing by Nigel Stephenson)