Euro-area government bonds surged, led by Italian and Spanishsecurities, after the European Central Bank (ECB) unexpectedly cutits benchmark interest rate to a record low, boosting demand forfixed-income assets.

Italy's two-year yield fell to the lowest level in more thanfive months, while the rate on Germany's two-year notes dropped tothe least since May. The ECB reduced the main refinancing rate by25 basis points to 0.25 percent. The decision was forecast by threeout of 70 economists in Bloomberg News survey, with the remainderpredicting no change. ECB President Mario Draghi, speaking toreporters in Frankfurt, said weaker growth is a downside risk toinflation.

“The euro region is likely to get stuck in a low-growth,low-inflation environment for a while,” said Harvinder Sian, afixed-income strategist at Royal Bank of Scotland Group Plc inLondon. “For the ECB's easing bias to have any meaningfulcredibility at all, it has to act. And it did.”

Italy's 10-year yield fell nine basis points, or 0.09 percentagepoint, to 4.12 percent at 3:40 p.m. London time after reaching 4.04percent, the least since May 28. The 4.5 percent bond maturing inMarch 2024 rose 0.765, or 7.65 euros per 1,000-euro ($1,337) faceamount, to 103.525. Italian two-year yields fell as much as 18basis points to 1.24 percent, the lowest since May 20.

Spain's 10-year yield fell eight basis points to 4.07 percent,the biggest fall since Oct. 22. The rate on the nation's two-yearnotes dropped eight basis points to 1.45 percent.

Inflation Slows

Data released on Oct. 31 showed the annual inflation rate in the 17-nation currency bloc fell to0.7 percent, the lowest since November 2009.

The ECB now has just one more quarter-point cut left beforereaching zero, increasing the likelihood of unconventional toolssuch as quantitative easing or a negative deposit rate if pricesslow further or the economic recovery stalls. Euro-area inflationis less than half the ECB's 2 percent target, and unemployment isat the highest level since the currency bloc was formed in1999.

The ECB kept its deposit rate at zero and trimmed the marginallending rate to 0.75 percent.

Pledging to keep borrowing costs low for an “extended period,”Draghi said weakening price pressures justified the ECB's surprisedecision to cut its main interest rate.

“We may experience a prolonged period of low inflation,” Draghitold reporters after the central-bank decision.

The additional yield, or spread, investors demand for holdingItalian 10-year bonds vs. their German equivalents narrowed fourbasis points to 242 basis points after dropping to 236 basispoints, the least since Oct. 24. Spain's 10-year yield spread overGermany tightened three basis points to 238 basis points.

“The strong gain in peripheral bonds today reflects a markettheme that looser policy and more liquidity will benefit countrieslike Italy and Spain more than core countries like Germany,” saidLyn Graham-Taylor, a fixed-income strategist at RabobankInternational in London. “We expect the yield spread tighteningtrend to continue.”

Spain sold 1.14 billion euros of 10-year securities today at thelowest auction yield in more than three years. The Madrid-basedTreasury allotted the 2023 bonds at an average yield of 4.164percent, compared with 4.269 percent at a previous sale on Oct. 3.Investors bid for 2.57 times the amount of debt on offer versus1.96 times in October.

Unlimited Cash

Draghi said that the central bank will extend its unlimitedofferings of one-month and three-month cash until the middle of2015.

“We continue to monitor closely money market conditions andtheir potential impact on our monetary policy stance,” Draghi said.“We are ready to consider all available instruments.”

Germany's 10-year yield fell five basis points to 1.69 percent.The two-year rate dropped five basis points to 0.09 percent afterdeclining to 0.05 percent, the least since May 31.

The German 10-year break-even rate dropped three basis points1.54 percentage points, matching the lowest since June 25, based onclosing prices. The rate, a gauge of inflation expectations, isderived from the yield difference between bunds and index-linkedsecurities.

Five-year inflation swap rates, a market gauge of price- growthexpectations over that period, declined to 1.34 percent on Nov. 1.That's within one basis point of the level reached in June lastyear, which was the lowest since December 2008. The rate slid twobasis points to 1.37 percent today.

The implied yield on Euribor contracts expiring in December2014, a measure of the outlook for three-month money-market rates,fell seven basis points to 0.345 percent, after dropping to 0.27percent.

Italian securities gained 6.4 percent this year throughyesterday, according to Bloomberg World Bond Indexes. Spain'sreturned 11 percent, while Germany's lost 1.3 percent.

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