Hit by Catalonia crisis, Spanish bonds brace for auction test

London: Spanish borrowing costs rose to their highest level since March on Thursday ahead of an auction that is shaping up as a test of investor appetite towards Spanish assets as Catalonia moves towards declaring independence from Spain. 

Spain will auction up to 5.25 billion euros of bonds, including a new five-year bond, an inflation-linked bond due in 2024 and a bond due in 2029.

The auction is expected to test appetite for Spanish government debt amid a crisis sparked by a banned independence referendum in the wealthy region of Catalonia last weekend.

"I expect the auction results to be weak given the conflict over Catalonia," said DZ Bank strategist Sebastian Fellechner. "Catalonia concerns are likely to take centre stage."

Rating agency S&P late on Wednesday put Catalonia`s ratings on "credit watch negative" on an escalation of the political conflict. S&P`s long-term rating for Catalonia is B+, four notches below investment grade.

Catalan President Carles Puigdemont said on Wednesday he favoured mediation to find a way out of the crisis but that Spain`s central government had rejected this. Prime Minister Mariano Rajoy`s government responded by calling on Catalonia to "return to the path of law" first before any negotiations.

Catalonia will move on Monday to declare independence from Spain.

The crisis in the euro zone`s fourth biggest economy has sparked a sharp selloff in both Spanish bond and stock markets. 

On Wednesday, Spain`s IBEX stocks index posted its biggest one-day fall since the Britain`s Brexit referendum in June 2016 sparked turmoil in financial markets.

Spain`s 10-year bond yield has risen around 19 basis points so far this week, putting it on track for its biggest weekly rise since March.

It rose 3 basis point to 1.807 in early Thursday trade, its highest level since March. 

The premium investors demand holding Spanish bonds over top-rated German peers was at 134 bps, having stretched to around 136 bps the previous session -- its widest since late April.

"Even though our base case assumption remains that Catalan independence (even if unilaterally declared) will not happen, we suspect things might still get worse before they get better, and target a return of the 10-year Spain/Germany (yield spread)to back above 140 bps," analysts at ING said in a note. 

Germany`s 10-year bond yield rose 1 basis point to 0.46 percent, rising in line with most other eurozone bond yields.

The focus was expected to turn to the minutes of the last meeting of the European Central Bank, due out later in the day.

That comes as investors try to assess the likely timing and scale of an unwinding of the ECB`s massive stimulus scheme.