* Italy sells five and 10-year bonds
* Spanish yields rise, German yields hit record low
* German Bunds come off record high after EU comments
* Irish yield curve inverts before Thursday’s referendum
By Ana Nicolaci da Costa
LONDON, May 30 (Reuters) - Italian government bond yields broke above the 6 percent danger level on Wednesday as investors required higher returns to buy debt issued by the euro zone’s third largest economy at an auction tainted by banking troubles in neighbouring Spain.
Italy’s funding costs rose sharply at a sale of five- and 10-year bonds on Wednesday, as concerns over Spain’s finances hurt appetite for riskier euro zone debt only weeks before Greece faces an election which is expected to determine its membership of the single currency.
Market players are worried about Spain’s plans to raise new funds to recapitalise nationalised lender Bankia when the country’s borrowing costs are rising daily and are flirting with euro-era highs.
German Bund futures jumped to record levels as investors sought security. They came off those highs as European stocks pared losses after the European Union Commision said the euro zone should move towards the direct recapitalisation of banks from its permanent bailout fund.
Italy raised 5.73 billion euros, at the mid-point of a planned issue range, helped by domestic demand.
“There was a huge concession before the auction and even despite that, both bonds came out with a weak price - below the market. The ‘risk off’ we have seen in markets is affecting especially Spain, but also Italy,” said Alessandro Giansanti, rate strategist at ING.
“Yields and spreads are back to January levels and the indications are the market is going back to the danger zone.”
Italian 10-year yields rose above 6 percent for the first time since mid-May to as high as 6.155 percent. It was up 17 bps on the day at 6.08 percent.
The Spanish equivalent jumped 19 bps to 6.7 percent - only a whisker away from euro-era highs. Beyond 7 percent, funding costs are seen as unsustainable.
Spain will soon issue new bonds to fund ailing lenders and indebted regions - a move which is set to put further pressure on already stretched finances.
Analysts are concerned that Bankia could be the tip of the iceberg of an overleveraged banking system.
They worry that troubles related to weak banks - the result of a burst property bubble aggravated by recession - and indebted regions could eventually force Spain to seek an international bailout the region can ill afford.
European Central Bank policymaker Ewald Nowotny said on Tuesday it was up to governments to rescue banks that get into trouble - a blow to those hoping the ECB would step in soon. .
“The news flow in Spain continues to deteriorate quite quickly,” a trader said. “They are getting to a stage where they can’t fund themselves at a time when they are talking about having to do extra issuance to a) fund the banks and b) fund the regions.”
Against this uncertain backdrop, investors took refuge in German government bonds even though they were becoming increasingly expensive.
German Bund futures rose to an all-time high of 144.98 and yields on all maturities on German bonds fell to record lows.
With two-year bonds offering hardly any returns - a record low of 0.012 percent - investors moved up the yield curve.
Ten-year yields shed 4.5 bps to 1.32 percent and 30-year yields slumped 7.1 bps to 1.86 percent, flattening the yield curve.
“1.20 (percent) in 10-year yields cannot be excluded. The situation is just so fragile, we have so many risks in Spain,” said Michael Leister, strategist at DZ Bank.
“Our view has been ... that any sort of pullback here in Bunds you should see as a buying opportunity, and be long Bunds either outright or by a curve flattener.”
Elsewhere, two-year Irish borrowing costs momentarily rose above 10-year bond yields for the first time since January.
The inversion of the Irish yield curve, which can indicate that investors see greater risks to the repayment of their cash in the short term than over a longer time period, came a day before the country’s referendum on new EU fiscal rules.
Polls are showing the pact will pass but Irish voters have rejected EU treaties in similar referendums in the past. A ‘No’ vote would threaten Ireland’s access to futher bailout funds if it cannot return to bond markets as planned when its current aid deal expires.
“If you can imagine a general risk-off environment, investors aren’t really going to be hugely reassured by opinion polls against the possibility of a shock result,” said Austin Hughes, chief economist at KBC Ireland.