Spanish bond yields rose to the highest in more than a week asinvestors speculated the 100 billion-euro ($125 billion) bailoutfor lenders may fall short, while binding the banks and sovereignmore closely together.

The lifeline from the euro area, aimed at loosening theconnection between banks and the state, risks doing the opposite asforeign investors continue to shun the nation's bonds and PrimeMinister Mariano Rajoy's government grows increasingly dependent ondomestic lenders.

“This 100 billion will be added to the public finances of Spain,so it just reinforces the link between banks and the sovereign,”Olly Burrows, credit analyst at Rabobank International, said in aphone interview from London. “Spain is receiving funds to bail outits banks, which have been buying Spanish debt while everyone elsehas been getting out.”

Spain agreed to take the aid in loans to be added to the publicdebt burden that rose to 69 percent of gross domestic product lastyear. The loans, which Economy Minister Luis de Guindos said willcarry an interest that's more favorable than market rates, will bechanneled through the country's bank-rescue fund.

The yield on Spain's 10-year bonds rose 12 basis points to 6.63percent, approaching a euro-era record of 6.78 percent reached onNov. 17. The gap with equivalent German securities was unchanged at529 basis points.

While Spain said the loans would “not undermine the presentconditions” of outstanding Spanish debt, Germany said the aidshould come from the euro area's permanent backstop, which givespreferred status to official creditors over other bondholders.

Foreign investors cut their share of Spain's outstanding debt to37 percent in April from 50 percent at the end of last year,Treasury data show. That left Spanish banks, helped by emergencyloans from the European Central Bank, to make up the difference.They increased their share to 29 percent from 17 percent over thesame period.

Capital Flight

Spain saw 22.6 billion euros of foreign investment in stocks andbonds leave the country in March, compared with 2 billion euros ayear earlier, Bank of Spain data show. At a debt auction on May 17,foreign investors accounted for just 20 percent to 30 percent ofbuying, a government official who declined to be named toldreporters in Madrid.

“Non-residents are likely to continue to reduce their exposureto the Spanish sovereign, until the fiscal situation shows definitesigns of improvement, which means that Spanish banks will have tocontinue to take up the slack,” said Gilles Moec, co-chiefeconomist at Deutsche Bank AG in London.

Spanish banks were among the biggest beneficiaries of 1 trillioneuros of three-year emergency loans from the ECB, which wererecycled into sovereign bonds in a trend Economy Minister Luis deGuindos said in April “increased the correlation between sovereignrisk and banking risk.” The ECB may need to offer another round ofthat financing to ensure local banks can fund the sovereign, Moecsaid.

A day before Spain sought the bailout, Moody's Investors Servicesaid on June 8 it may review Spain's A3 credit rating as a rescuebecame more likely and estimates of the cost of shoring up banksincreased. As a bailout approached, “the increased risk to thecountry's creditors may prompt further rating actions,” Moody'ssaid.

Still, Standard & Poor's Ratings Service said the bankbailout had no immediate effect on its BBB+ rating of Spain. Theloan would have to “materially exceed” the 100 billion-euro ceilingfor the preferred creditor status of the ESM to “reduce thelikelihood of bondholders being paid in full,” the company said ina statement.

As Spain suffers its second recession since 2009 andunemployment exceeds 24 percent, banks' bad loans are set to keeprising, increasing the risk for the sovereign. The deepestausterity measures on record are undermining demand as thegovernment tries to cut the deficit to 3 percent of GDP next yearfrom 8.9 percent in 2011.

“There's a risk of bailout creep,” said Nicholas Spiro, managingdirector of Spiro Sovereign Strategy in London. “The question onthe lips of every investor in the coming days and weeks will be:will the Spanish sovereign be next?”

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