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

The lifeline from the euro area, aimed at loosening the connection between banks and the state, risks doing the opposite as foreign investors continue to shun the nation's bonds and Prime Minister Mariano Rajoy's government grows increasingly dependent on domestic 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 a phone interview from London. “Spain is receiving funds to bail out its banks, which have been buying Spanish debt while everyone else has been getting out.”

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

The yield on Spain's 10-year bonds rose 12 basis points to 6.63 percent, approaching a euro-era record of 6.78 percent reached on Nov. 17. The gap with equivalent German securities was unchanged at 529 basis points.

While Spain said the loans would “not undermine the present conditions” of outstanding Spanish debt, Germany said the aid should come from the euro area's permanent backstop, which gives preferred status to official creditors over other bondholders.

Foreign investors cut their share of Spain's outstanding debt to 37 percent in April from 50 percent at the end of last year, Treasury data show. That left Spanish banks, helped by emergency loans from the European Central Bank, to make up the difference. They increased their share to 29 percent from 17 percent over the same period.

Capital Flight

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

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

Spanish banks were among the biggest beneficiaries of 1 trillion euros of three-year emergency loans from the ECB, which were recycled into sovereign bonds in a trend Economy Minister Luis de Guindos said in April “increased the correlation between sovereign risk and banking risk.” The ECB may need to offer another round of that financing to ensure local banks can fund the sovereign, Moec said.

A day before Spain sought the bailout, Moody's Investors Service said on June 8 it may review Spain's A3 credit rating as a rescue became more likely and estimates of the cost of shoring up banks increased. As a bailout approached, “the increased risk to the country's creditors may prompt further rating actions,” Moody's said.

Still, Standard & Poor's Ratings Service said the bank bailout had no immediate effect on its BBB+ rating of Spain. The loan would have to “materially exceed” the 100 billion-euro ceiling for the preferred creditor status of the ESM to “reduce the likelihood of bondholders being paid in full,” the company said in a statement.

As Spain suffers its second recession since 2009 and unemployment exceeds 24 percent, banks' bad loans are set to keep rising, increasing the risk for the sovereign. The deepest austerity measures on record are undermining demand as the government tries to cut the deficit to 3 percent of GDP next year from 8.9 percent in 2011.

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

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Spain Bailout Prompts Bond Selling

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