Spanish bond yields jump after bill sale

LONDON (Reuters) - Spanish bond yields rose on Tuesday after demand at a bill sale fell despite the significantly higher returns on offer to investors and hopes faded that an EU summit later this week would produce game-changing crisis measures.

Finance ministers of Germany, France, Italy and Spain will hold talks on Tuesday evening to try to narrow differences on the currency area's future, but no short-term fix is expected to emerge from any of the meetings.

Safe haven German Bunds pared losses after sources cited German Chancellor Angela Merkel saying Europe will not have shared total liability for debt as long as she lives, squashing hopes for common euro zone bonds, which have been advanced by some countries as one potential crisis solution.

"The market last week was hoping that we might see something substantial, but hopes seem to be fading now," RIA Capital Markets bond strategist Nick Stamenkovic said.

Amid shaky market sentiment, Spain saw a falling size of bids in relation to the amount of debt on offer at a sale of over 3 billion euros of bills. Borrowing costs rose sharply, with the yield on the 3-month bill nearly tripling from a month ago.

"If you're looking for a sign that things aren't good, that's one right there," a trader said.

Italy fared better at a sale of zero coupon and inflation-linked bonds with traders saying results were in line with expectations.

Spain formally requested aid for its banks on Monday, becoming the fourth euro zone country to access rescue funds and - while expected - a Moody's downgrade on 28 Spanish banks did nothing to help sentiment.

Cyprus quickly followed, asking for a bailout, both for its banking sector, hit by exposure to Greece, and to help cover its budget deficit.

Spanish 10-year bond yields rose 23 basis points to 6.87 percent. Two-year yields were 42 basis points higher at 5.29 percent, adding to Monday's 40 basis points gain.

The underperformance of shorter-term debt is indicative of the market's perception that the risk of a credit event in Spain has risen.

Italian short-dated paper also underperformed, with two-year yields up 32 bps at 4.68 percent, a sell-off which analysts said signaled domestic investors may have made enough room for short-dated paper in their books before a T-bill sale of up to 9 billion euros on Wednesday.

Italy is also selling up to 5.5 billion euros worth of five- and 10-year bonds on Thursday.

"The short-end has clearly underperformed as it prepares for the supply," Stamenkovic said. "And given the sell-off that we've seen in the past few days ... I think (the Italian auction on Thursday) should go down reasonably well."

SUMMIT HOPES FADE

The Financial Times reported that the EU could gain far-reaching powers to rewrite national budgets for euro zone countries that breach debt and deficit rules under proposals likely to be discussed at the summit.

Although seen as a step forward towards reaching closer fiscal union within the euro zone, such a move is not seen as powerful enough to stem selling pressure on Spanish and Italian bonds in the short-term.

"The realization is that we tend to get a piecemeal outcome from summits rather than a grand solution so there isn't a lot of faith in the process at this point," ING rate strategist Padhraic Garvey said.

September Bund futures were 34 ticks lower at 141.81, reversing some of Monday's near 130-tick rally, with 10-year yields up 3.4 bps at 1.5 percent.

Traders said a raft of triple-A rated issuance was weighing on the safe-haven paper.

The Netherlands sold 2.17 billion euros of 10-year bonds, benefiting from demand for high-rated paper.

Austria, Finland and the European Union were also all in the market, with syndicated deals.

(editing by Ron Askew)