* Italy yields hit danger zone as sells 5, 10-year bonds
* Spanish yields rise, German yields hit record low
* European Commission offer to Spain gives little respite
* Irish yield curve inverts before Thursday's referendum
By Emelia Sithole-Matarise
LONDON, May 30 (Reuters) - Spanish government bond yields surged to a six-month high on Wednesday as deepening fears over the country's banking sector made investors dump riskier assets, driving safe-haven German yields to record lows.
Italian bond yields also rose, breaking above the 6 percent danger level as investors required higher returns to buy debt issued by the euro zone's third largest economy at an auction tainted by angst over Spain.
Investors 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 nearing the 7 percent level that led Ireland and Portugal to seek bailouts.
The European Commission threw Spain two lifelines, potentially offering it more time to reduce its budget deficit and direct aid to recapitalise its weak banks from the region's rescue fund.
But this offered markets little relief, with Spanish 10-year yields rising 24 basis points on the day to 6.74 percent.
Analysts said the Commission's proposals were not a forgone conclusion as they needed the approval of euro zone states and were also conditional on Madrid meeting budget requirements.
"Those proposals where the EU commission is looking at possibly the ESM (rescue fund) supporting the banking sector is a long way off and it's not agreed," said Charles Diebel, head of market strategy at Lloyds Bank.
"You're once again left with the policymakers looking like they haven't really got much of a coordinated policy response thereby yields continue to rattle higher and it worsens the funding situation."
The premium investors demand to hold Spanish debt over German benchmarks rose to its highest since the launch of the euro at 543 basis points, while the cost of insuring against a Spanish default hit a record high near 600 basis points.
Two-year Spanish yields jumped more than 40 bps to 5.17 percent, rising faster than yields on longer maturities, further flattening the 2/10-year yield curve in a move that could make it more difficult for Spain to issue the shorter-dated debt it has favoured so far this year.
European Central Bank data showing Spanish banks' appetite for the country's sovereign bonds receded in April added to investor worries about Spain's ability to fund itself.
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.
"Most market makers think the tipping point for Spain becomes 7 percent (for yields) when either we get the SMP (ECB bond buying programme) coming in aggressively at that stage or Spain has to accept an aid programme," a trader said.
Italy's funding costs rose sharply at a sale of five- and 10-year bonds, with next month's election whose uncertain outcome is expected to determine whether Greece stays in the euro zone also weighing on sentiment.
"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.
Italian 10-year yields rose above 6 percent for the first time since mid-May to as high as 6.155 percent. They were last up 15 bps on the day at 6.06 percent.
Investors took refuge in German government bonds even though they were becoming increasingly expensive. German Bund futures rose to an all-time high of 145.44 and yields on all maturities on German bonds fell to record lows.
With two-year bonds offering hardly any returns - a record low of 0.002 percent - investors moved up the yield curve. Ten-year yields shed nine bps to 1.27 percent and 30-year yields slumped 11 bps to 1.82 percent, flattening the yield curve.
The search for safety also pulled benchmark U.S. Treasury notes to 60-year lows of 1.619 percent.
"There's no value in 10-year Treasuries or Bunds at these levels but it's nothing to do with value. It's to do with return of your money," Diebel at Lloyds said.
Elsewhere, two-year Irish borrowing costs momentarily rose above 10-year bond yields for the first time since January.
The inversion of the yield curve, which can indicate that investors see greater risks to the repayment of their cash in the short than the longer time, came a day before the country's referendum on new EU fiscal rules.