* Bund futures keep close to record highs; Spanish yields up
* Spanish debt auction seen finding enough demand
* But focus on borrowing costs, which are expected to rise
By Marius Zaharia
LONDON, May 17 (Reuters) - Spanish government bond yields rose on Thursday with markets focused on how much Madrid’s borrowing costs will rise at an auction of medium-term debt.
Nervousness in financial markets has intensified investor interest in debt auctions in Spain and Italy, which are among the countries most at risk of contagion from a political crisis in Greece that could see Athens quit the euro zone.
Domestic banks are expected to provide sufficient demand for the 1.5 to 2.5 billion euros of 2015 and 2016 Spanish bonds on offer, but they are also likely to require higher returns. This is a major concern as the country’s borrowing costs are already close to becoming unsustainable.
“It will probably go OK, but once the dust settles the realisation that this issuance is coming at an increasingly onerous cost should ultimately weigh on the market,” Rabobank rate strategist Richard McGuire said.
“The path of least resistance is certainly higher Spanish yields. The market remains concerned that the road is rapidly running out as regards the sustainability of Spain’s public finances.”
Spanish 10-year government bond yields were 6 basis points higher on the day at 6.38 percent, while five-year yields were 9 bps up at 5.48 percent.
Investors are also concerned over Spain’s banking sector, which is struggling with bad property loans. Clients of troubled Spanish bank Bankia, nationalised last week, have withdrawn more than 1 billion euros since last Wednesday, El Mundo newspaper said.
“The Spanish auctions are going to set the tone for today,” one trader said. “We’re very concerned ... I don’t see where the bids are going to come unless we get some magical large domestic interest as we’ve seen in the past.”
In Italy, 10-year yields were 2 bps higher at 6 percent. This level is closely watched by markets as it has in the past triggered an accelerated rise in bond yields in countries such as Portugal or Ireland.
Markets remained dominated by the risk that Greece may eventually leave the euro zone. Prices of German bonds, seen as a safe haven, stayed close to record highs hit this week.
Greeks heading to the polls again on June 17 after politicians failed to form a government after an inconclusive election on May 6. Leftists opposed to the terms of the country’s vital bailout package are expected to win the ballot.
If Greece does not receive further financial aid it risks default and may crash out of the euro zone.
Heightening fears that Athens is on the brink of collapse, the European Central Bank has stopped offering liquidity to some Greek banks it does not consider solvent.
Bund futures were last nine ticks higher on the day at 143.27, having hit record highs of 143.69 on Monday and Wednesday.
A break below Wednesday’s low of 142.83 was needed for a short-term pull-back in Bunds to be considered, Futurestechs technical analyst Clive Lambert said.
Otherwise a move to new record highs was expected, with the next resistance level at 145.02, the top of the channel formed by the session highs and lows during the rally kick-started in mid-March at levels between 135.00 and 136.00.
“The bulls are still in the box seat and all is good in their world,” Lambert said.