* Risk of Spanish bailout grows; bonds in free fall
* Greek funding worries add to peripheral pressure
* Bund yields set to mark new lows on safe-haven flows
By Kirsten Donovan
LONDON, July 23 (Reuters) - Spanish government bonds sank on Monday, pushing yields sharply higher, on fears the government will lose access to debt markets and need a full bailout as its regions began lining up for financial help.
Worry over Greece resurfaced with international lenders scheduled to gather in Athens to discuss the terms of further rescue payments, after its prime minister said the country was mired in a “Great Depression”..
As risk aversion dominated financial markets, five- and 10-year German government bond yields hit new lows and U.S. T-note yields hit their lowest since the early 1800s.
The Spanish region of Murcia moved closer to following Valencia in seeking financial aid from the government, which set up an 18 billion euro fund earlier this year to help the regions refinance their debt. Media reported half a dozen others were ready to do likewise..
“Given the market reaction on the back of the news that more and more regions are looking to tap into the liquidity fund..., it will be very difficult for Spain to circumvent further support for itself,” said Norbert Aul, a rate strategist at RBC Capital Markets.
Euro zone finance ministers approved on Friday a bailout for Spain’s banking sector, which along with fresh austerity measures and looser fiscal targets was aimed at avoiding a full rescue that the euro zone can barely afford.
But Spanish bond prices were in free-fall in illiquid markets, reflecting worries that the banking bailout alone was unlikely to be enough.
Ten-year yields, which rise as prices fall, were up 25 basis points at 7.53 percent and two-year yields were up 95 bps at 6.71 percent
Short-dated yields have risen more than longer-dated ones, flattening the curve, because of a perceived rise in credit risk, while a spread of around 110 cents between prices at which investors were willing to buy and sell 10-year paper reflects the lack of liquidity in the markets.
Italian bonds were pulled down with Spain‘s, with 10-year yields up 15 bps at 6.36 percent, rising above the Irish equivalent for the first time since January 2009.
While the euro zone’s bailout funds could scrape together enough cash to rescue Spain, analysts say there are insufficient funds to support Italy as well.
“The bid/offer spreads are so wide it’s nearly impossible to get anything done,” a trader said. “We saw some real money accounts selling Italy in volume first thing but that dried up once the market fell.”
Spain must make coupon and redemption payments to bondholders of 20 billion euros next Monday, followed by nearly 25 billion euros in October, according to Reuters data.
Looking further out, 60 billion euros worth of paper is due for repayment next year, with a similar amount due in 2014.
RBC’s Aul said Spanish auctions would become very difficult at current yields and that as soon as primary market access was at stake the likelihood the country would have to ask for support in some form would increase significantly.
“The first focus should be on any measures by the (euro zone rescue funds) that offer primary market support, as it is not feasible to take a sovereign of the likes of Spain completely off the primary market, as was the case for Ireland, Portugal and Greece.”
Markets players were again talking about a possible Greek euro exit after German news magazine “Der Spiegel” reported on Sunday that the IMF may not take part in any additional financing for Greece and other German newspapers said Berlin would be unlikely to sign off on any fresh aid.
September Bund futures were 32 ticks higher at 146.09, nearing June’s 146.89 record high after closing above a key resistance level on Friday. Ten-year yields marked new lows of 1.126 percent and five-years 0.22 percent.
Two-year German bond yields held comfortably in negative territory and were last at minus 6.5 basis points.
If the risk-off sentiment persists, investors will forego any returns at a two-year Dutch bond sale on Tuesday, effectively paying to lend to the country.
But the yield grab seen in secondary markets last week which spurred demand for slightly more risky debt such as paper issued by France, Belgium and Austria subsided on Monday, with yields on those bonds all rising.
“Some accounts have real problems taking sub-zero yields into their portfolio so we’ll probably see this buying continue but for the moment it looks like most of it was done last week before the holidays.” the trader said.