Spanish Yields Rise at Auction, French Yields Fall

Spanish yields rose at auction Thursday as fears that the banking bailout will become a liability on the country's balance sheet grew. The weak auctions of 2-, 5-, and 7-year bonds followed poor economic data on Wednesday which showed that home prices fell more than expected in the second quarter and that Spanish banks' asset quality deteriorated further in May.

Spain auctioned 2-, 5-, and 7-year bonds early Thursday, with yield rising at all maturities. Spain auctioned 1.36 billion euro of 2-year bonds with yields climbing to 5.204 percent from 4.335 percent at the previous auction. Spain also auctioned 1.07 billion euros of 5-year bonds as yields also rose to 6.456 percent from 6.072 percent at the last auction. Lastly, Spain sold 548 million euros of 7-year bonds with yields rising from 4.832 percent to 6.701 percent.

Even though yields rose, demand was strong at the auction, with the bid-to-cover for each maturity around 2. The strong demand at higher yields shows that, even though borrowing costs are rising for Spain, it is not yet shut out from financial markets like Greece, Ireland, and Portugal. If demand holds, it could signal that investors believe that Spain can escape the crisis.

Yields have been rising on Spanish bonds because investors are pricing in the extra liability that will rest on the government's balance sheet once it bails out the banking sector. The bailout from the Eurogroup is set to be funneled through Spain's own bailout fund, the FROB (Fund for Orderly Bank Restructuring). Thus, it is a loan to Spain that is then used to recapitalize the banks. The rise in yields reflects this increase in debt for the government.

Yields on peripheral debt have risen recently as the European Debt Crisis has thrust Spain and Italy to the forefront of the crisis. Meanwhile, yields on safer, core nations have fallen. France also issued bonds Thursday, seeing yields fall as investors clamored to the relative safety of French bonds. France sold 3-, 4-, and 5-year bonds at auction and yields on the 5-year priced at a record low of 0.86 percent.

The rise in peripheral yields can be explained by a flight to safety. However, the low, and even negative, yields of safer issuers can be explained both by this increased risk-aversion and by the European Central Bank's Longer-Term Refinancing Operations (LTRO's). The ECB gave financial institutions across Europe 3-year, 1 percent loans in exchange for quality collateral. To get these loans, banks bought lots of safe bonds to use as collateral, driving yields lower. Combined with the flight to safe bonds, yields have fallen much lower.

Economists predict further ECB easing over the next few months to help the ailing economy escape recession and keep yields as low as possible. Further LTRO's, should they happen, would most likely further exacerbate the spread in yields between safer issuers and more risky issuers.