* Spanish yields rise after rating cut to brink of “junk”
* Italian bonds pressured before auction
* Selling pressure on Bunds resumes after early gains
By Kirsten Donovan
LONDON, June 14 (Reuters) - Spanish government bond yields rose on Thursday after Moody’s cut the country’s credit rating to just one notch above “junk”, while Italian debt came under pressure before an auction which may prove tricky as the euro zone crisis deepens.
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. The agency 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 15 basis points to a euro-era high of 6.92 percent, but short-dated paper was even harder hit, with two-year yields up 18 bps at 5.15 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 teetering 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. This in turn pushes financing costs - already approaching levels seen as unsustainable - higher.
“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,” said ING’s head of investment grade strategy Padhraic Garvey.
“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.
Italy will test market sentiment with the sale of up to 4.5 billion euros of bonds. Demand is expected to be sufficient to place the paper but borrowing costs are set to rise sharply after yields at a one-year bill sale on Wednesday rose to close to 4 percent.
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 .
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.
Traders said dealers were trying to cheapen the paper before the auction and Italian 10-year yields were 4 bps higher at 6.26 percent.
With dealers obliged to absorb the issuance, markets will focus on the price at which the paper is sold relative to the secondary market.
“Typically there isn’t a great deviation from secondary market prices,” ING’s Garvey said. “But it is about the quality of the pricing.”
September Bund futures erased early gains as the selling pressure seen over the last two days re-emerged and were last flat at 141.71. German 10-year yields were a basis point higher at 1.51 percent.
The sell-off was led by longer-dated paper. Thirty-year German yields were up 7 bps with traders citing 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.”