* Investors pay Germany at 2-year debt auction
* Spain, Italy jitters support demand for German debt
* Spain to face own market test in Thursday auction
By Marius Zaharia and Emelia Sithole-Matarise
LONDON, July 18 German government bond yields
fell to six-week lows on Wednesday and investors paid Berlin to
look after their money for two years for the first time ever as
worries about the euro zone debt crisis fueled flows into safe
Spain remains at the forefront of the crisis and worries
that it may need a sovereign bailout in addition to the aid
already agreed for its banks, are keeping its 10-year yields
around 7 percent, a level widely deemed as unsustainable.
Markets are nervous. Media reports quoting German Chancellor
Angela Merkel as saying that the European project was "not yet
shaped so that we can be sure that everything will turn out
well," pushed Bunds higher and weighed on Italian and Spanish
debt, traders said.
Merkel was quoted as going on to say she was optimistic the
project would work, repeating her usual comments, but investors
only focused on the first part.
Against this backdrop, the sale of 4.17 billion euros of
zero coupon two-year German bonds drew the strongest demand
since a January sale of a similar maturity as investors sought
capital preservation over returns.
It was the first time such paper attracted a negative yield
at an auction, meaning bidders will get back less than they
spent on the bonds.
This unusual behaviour of investors may become the new norm
in euro zone debt markets, Societe Generale rate strategist
Ciaran O'Hagan said.
"People are looking for security because we are in troubled
times and times will remain troubled," said O'Hagan, adding that
investors' search for safe assets is likely to fuel further
gains in bonds issued by triple-A and double-A rated countries.
In secondary markets, German, Dutch and Finnish two-year
bond yields entered negative territory in recent days, while
French, Austrian and Belgian bond yields are not far above zero.
The Bund future was last up 21 ticks at 145.33,
while 10-year Bund yields were 3 basis points down
at 1.20 percent, not far from a record low of 1.127 percent hit
Some market participants expect the Bund yield to fall below
1 percent by year-end given doubts about the ability of
policymakers to resolve a crisis that is clouding the global
"We're looking for sub-1 percent yields for German
10-years...so any move up to 1.5 percent will be an opportunity
to get involved," said Stuart Frost, who manages the
conservative RWC Absolute Return Bond and Currency Fund.
Spanish 10-year yields were up 13 bps at 6.97 percent
, a whisker from the 7 percent mark beyond which
many analysts consider borrowing costs could become unaffordable
as happened with Greece, Portugal and Ireland.
Spain may face more selling pressure in bond markets ahead
of a 3 billion euro auction of paper with maturities up to seven
years on Thursday. Although Madrid's borrowing costs for
12-month treasury bills fell from a month ago at an auction on
Tuesday, they remained high by historic standards.
"There will be a fair amount of coercion for (Spanish
banks)... to support the auction but we are not seeing a drift
lower in yields that we need to see to get investors back. We
need to see Spanish yields with a 5 percent handle not at 6
percent," Lloyds strategists Charles Diebel said.
"A lot of investors are very cautious," he said,
recommending selling German 10-year Bunds when yields fall near
1.20 percent and buying when they rise to 1.35 percent.
Italian 10-year yields were four basis points up at 6.07
percent, with two-year debt underperforming,
yielding 8 bps more on the day at 3.96 percent.