* Demand falls at German debt sale due to low returns
* But concerns over Spain to keep German debt in high regard
* Yields not seen backing up too far after debt sale
By Marius Zaharia and Sarah Marsh
LONDON/BERLIN, April 11 (Reuters) - Safe-haven Germany offered the lowest ever return of 1.75 percent on its 10-year government bonds on Wednesday, dampening demand for its debt despite concerns about Spain and Italy.
Investors sold Spanish debt on Tuesday and yields jumped at an Italian bill auction on Wednesday, on doubts about whether those countries can keep debt and deficits in check. This had drawn attention to the auction of Germany’s low risk debt.
As was the case at the height of the euro zone debt crisis in November last year, the low yields in Germany led to fewer bids than the amount on offer, a phenomenon which debt experts term as a technically uncovered auction.
The new 10-year Bund offered a record low coupon of 1.75 percent and the average yield at auction was 1.77 percent, also an all-time low.
“The market looks to have got a nosebleed at these levels,” Credit Agricole rate strategist Peter Chatwell said.
The debt agency said the result of the sale was “good” and that it was in line with its plans, even though Germany kept around 23 percent of the full amount on its books, higher than this year’s average.
Germany usually holds back a portion of the amount on offer at debt sales, which it uses for market smoothing operations. A large retention rate can be a sign of faltering investor demand, analysts say.
“The fact that this auction was undercovered is not an indicator of the attractiveness of the bond because it was the first issuance,” debt agency spokesman Boris Knapp told Reuters.
The retention rates at previous German 10-year auctions have averaged 18.5 percent this year, much lower than at the Wednesday sale. The bid/cover ratio of 1.1 compared with an average 1.37 percent at similar auctions so far this year.
But analysts said the agency’s comments were justified. They also expected the next taps of the bond to be better bid as either yields will back up slightly or the euro zone crisis will intensify, boosting demand for safe haven assets.
“It was a timing issue, it came when yields had significantly fallen,” said DZ Bank rate strategist Michael Leister.
The average yield of 1.77 percent at the sale was an all-time low. Ten-year cash yields were 7.3 basis points higher on the day at 1.715 percent versus 1.685 percent before the auction.
As in November, the post-auction sell-off is expected to be a brief set-back as confidence that Spain can keep its public finances in check is waning, rekindling fears that the country could become a source of contagion for the euro zone.
“I don’t think the issues have dissipated overnight. We’ve still got big uncertainty around Spain and there’s a similar situation in Italy,” Lloyds rate strategist Eric Wand said.
Mirroring these concerns, Italy’s one-year borrowing costs doubled at a sale of short-term bills on Wednesday.
Credit Agricole’s Chatwell said 10-year Bund yields might back up to the 1.80-2 percent range after the auction. Bunds yielded as much as 3.5 percent last year.
Highlighting how far Germany’s borrowing costs have fallen, two-year German yields dipped below their Japanese counterparts for the first time since 1991 on Tuesday, according to Reuters data.
Japan’s 10-year yields have averaged just 1.4 percent since 2000 when a property bubble burst, leading to a harsh round of deleveraging and ultra-easy monetary policy that is still in place now.
But Germany is in a different situation. Its economy is healthier, with debt expected to reach just over 80 percent of its economic output this year, while Japan is heading towards 240 percent.
Markets may use Germany’s better growth prospects as an argument to demand slightly higher yields from the euro zone powerhouse in the future.
“There are far more differences than similarities,” said Simon Smith, chief economist at FxPro. “Japan’s (yields) are a function of many years of slow growth and deflation risks, whereas German yields are (low) because investors are parking money there in a safety play.”
“It is a symptom of the general move to safety and ranking return of capital over the return on capital. But from a fundamental perspective yields look rich.”