* 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 (Reuters) - 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 haven assets.
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 in June.
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 growth outlook.
“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.