Spanish Bonds Slide on Downgrade as Bailout Looms; Bunds Advance

June 7 (Bloomberg) -- Fitch Ratings cut Spain’s long-term credit rating to BBB and left it two notches from junk, citing the cost of recapitalizing the country’s banking industry and a lengthening recession. (Source: Bloomberg)

Spanish bonds fell, with 10-year yields snapping a six-day gain, after Fitch Ratings cut the nation’s credit grade to within two steps of junk and said the economy will struggle to emerge from recession.

German bunds rose for the first time in five days as reports showed Italian industrial production and French business confidence dropped, boosting demand for the region’s safest securities. Spain’s bonds still headed for their first weekly gain in a month amid optimism Prime Minister Mariano Rajoy will win a compromise with European peers on financial aid to shore up its banks as soon as this weekend.

“The market’s reaction to the downgrade needs to be seen in terms of the past few days,” said Alessandro Mercuri, a London-based interest-rate strategist at Lloyds Banking Group Plc. “There’s been a bit of a reversal of that. The market is convinced that an external solution to Spain’s problems is needed.”

The Spanish 10-year yield climbed 13 basis points, or 0.13 percentage point, to 6.22 percent at 4:02 p.m. London time after dropping 57 basis points in the previous six days. The 5.85 percent bond due in January 2022 fell 0.895, or 8.95 euros per 1,000-euro ($1,245) face amount, to 97.37.

The extra yield investors demand to hold the securities instead of similar-maturity German bunds widened 15 basis points to 486 basis points. The spread expanded to a record 548 basis points on June 1.

Fitch Downgrade

Fitch downgraded Spain by three levels to BBB, saying the cost to the state of shoring up banks may amount to as much as 100 billion euros in the worst case, compared with its previous estimate of 30 billion euros. The economy is set to remain in recession through 2013, the ratings company said, having earlier forecast a recovery for next year.

Spain may request emergency aid as soon as tomorrow when euro finance ministers hold a conference call, said a German government official and a European Union aide, each of whom declined to be identified because the matter is confidential.

“The rally we saw earlier this week reflects the market thinking there is going to be a policy response, and it is well- targeted to the recapitalization of the Spanish banks,” said Mohit Kumar, head of European interest-rate strategy at Deutsche Bank AG in London. “The market is behaving as if a positive response is imminent.”

German Bunds

German bunds rose along with U.S. Treasuries and U.K. gilts as the European reports added to evidence the region’s debt crisis is slowing growth.

Italian industrial production dropped 1.9 percent in April from March, when it rose a revised 0.6 percent, Rome-based statistics office Istat said. Sentiment among French factory executives declined in May to 93 from a revised 94 in April, the Bank of France said in an e-mailed statement.

The German 10-year yield fell four basis points to 1.34 percent after climbing to 1.42 percent yesterday, the highest level since May 25. The yield dropped to a record low 1.127 percent on June 1.

German borrowing costs have plunged this year as investors sought the nation’s debt as a haven from Europe’s financial turmoil. Austrian, Belgian, Finnish, French and Dutch bond yields also reached all-time lows as concern mounted that Greece will exit the euro area after inconclusive elections on May 6. A second Greek vote is scheduled for June 17.

European Central Bank Governing Council member Ewald Nowotny said the central bank may cut interest rates if the economic outlook dims further.

‘Downside Risks’

While the ECB never pre-commits on future policy actions, it “sees increased downside risks” on the economy and “may have to react,” Nowotny said in Vienna when asked about the likelihood of an interest-rate cut next month.

The central bank left its benchmark interest rate at a record low 1 percent at a policy meeting on June 6.

“Nowotny’s signal that a rate cut is on the cards is probably helping the bid for bunds rather than supportive for risk appetite,” John Davies, a fixed-income strategist at WestLB AG on London, wrote in an e-mailed report.

Germany’s two-year yield slid two basis points to 0.05 percent. The yield will struggle to rise above its 50-day moving average currently at 0.09 percent, according to Bloomberg data.

Italy’s 10-year bond yield climbed five basis points to 5.76 percent. The yield on Greece’s 2 percent security due in February 2023 increased 28 basis points to 28.93 percent. The price fell to 14.78 percent of face value.

German debt has returned 3.5 percent this year, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. Spanish securities lost 2.3 percent, and Italian bonds earned 8.8 percent.

Spanish yields remain below those of Portugal and Ireland when they requested bailouts. The Portuguese 10-year yield was 8.54 percent on April 6, 2011, the day it requested European Union aid. By May 6, 2011, the yield had climbed to 9.56 percent. Ireland’s 10-year debt yielded 8.12 percent on Nov. 19, 2010, before the nation requested aid from the EU and International Monetary Fund. By the end of that year, the yield had reached 9.06 percent.

To contact the reporters on this story: David Goodman in London at dgoodman28@bloomberg.net; Keith Jenkins in London at kjenkins3@bloomberg.net

To contact the editor responsible for this story: Daniel Tilles at dtilles@bloomberg.net

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