Spain Passes Second Bond Auction Test with €4.6bn Sale Amid Global Market Jitters

Spain's Treasury closed the books on nearly €10bn in bond auctions this week that some traders say may be enough to delay its need for a formal financial rescue from its European Union partners.

Thursday's sale of three and 10 year notes raised just under €5bn for the recession-hit Spanish government after a similar amount of short-term Treasury bills were sold Tuesday at significantly lower rates than in previous months thanks to the market impact of the European Central Banks pledge to offer an unlimited amount of financial support to lower Spain's borrowing costs.

However, the successful auctions may give Prime Minister Mariano Rajoy reason to believe he can avoid seeking a formal EU bailout that could delay solutions on the myriad issues he faces in attempting to steer Europe's fourth-largest economy out of its worst recession in a generation.

The next few weeks will likely define Spain's ability to both manage its internal finances and command the confidence of its international lenders as Rajoy's government prepares to deliver its 2013 budget plans, publish the detailed results of its comprehensive banking sector audit and awaits the result of Moody's Investors Service's review of its investment grade debt rating.

If any of these events spook investors, the recent impact of the "Draghi Effect" - the sharp fall in Spain's borrowing costs from ECB President Mario Draghi's bond purchase programme - could quickly reverse and Spain could be forced into a formal bailout at the European Leaders' Summit in mid-October.

Spain benchmark €859m 10-year bond auction drew an average yield of 5.66 percent - nearly a full percent lower than a similar sale last month and with stronger investor demand. It's larger of the two sales - a €3.9bn offering of new 3-years notes - drew an average yield of 3.845 percent.

The latter sale is a clear indication of the Draghi Effect in that the bond-buying programme, known as Outright Monetary Transactions (OMTs), will focus on shorter-duration bonds issued by cash-strapped governments.

The key to the ECB's intervention, however, is that any country which enters the programme will first need to apply for and be accepted into an international rescue framework with the EU and the International Monetary Fund, something Rajoy has been reluctant to commit to since the conditions were first set out during Draghi's 2 August press briefing in Frankfurt.

Since then benchmark 10-year bond yields have plunged more than 2.5 percent and Spanish stocks have rallied more than 25 percent.

Investors asked for a 2.835 percent return on the €3.56bn in 12-month bills sold by Spain's Treasury, a 70 basis point improvement from the previous auction. Demand for the paper, however, was tepid, with investors bidding €2 for every €1 for sale - only slightly better than the August sale. Spain also sold €1.02bn in 18-month bills at a yield of 3.07 percent, again at a lower yield than in prior sales but with weaker demand: only €3.6 was bid for every €1 on offer, compared to €4 at last month's auction.

Critical to Spain's ability to use the time bought by the Draghi Effect to avoid a bailout will be its plans for the funding and budget needs of its 17 semi-autonomous regions, which collectively contribute to nearly a fifth of Spain's overall debts and more than a third of its annual deficit.

Spain's federal government has set up a domestic rescue fund of around €18bn to help the regions refinance maturing debt, but a good portion of that funding comes from Spain's troubled banking sector, whose debts are among the highest - at 340 percent of GDP - in the whole of the Eurozone.

Moody's Investors Service will also complete its review of Spain's Baa3 debt rating, which sits just one notch above "junk" status at present. A cut below that threshold could precipitate a sharp rise in bond yields, as many institutional investors could be forced to sell securities after losing the investment-grade rating. Standard & Poor's said earlier this week it does not expect to cut the investment grade rating it holds for Spain in the near-term.

Fitch Ratings slashed its rating on Spain to BBB, the cusp of investment grade, in June and warned it may lower the assessment further given "the risks associated with a further worsening of the Eurozone crisis, notably contagion from the ongoing Greek crisis.

The following month it said the governments regional funding commitments were "extremely challenging" and that its plans to offer financial support was a "temporary solution" that required "strong vigilance".

"Spanish banks and regions are too large for the central government to support them all, in our view," wrote RBS analysts Alberto Gallo and Lee Tyrrell Hendry in a client note. "The ECB new bond buying program has in part realigned sovereign yields, but is not realigning peripheral and core real economies, and it will not fix Spain's problems on its own".

Those problems are indeed significant. Barclays expects the current recession to extend well into the next two years - with a 1.8 percent contract in 2013 - and its budget deficit to miss government and EU targets by a wide margin. Unemployment is at a record-high 24.6 percent and house prices fell a record 14.4 percent in the last quarter.

"While recent positive market developments may have lowered government incentive to put forward a formal request, we believe that - sooner or later - market attention will re-focus on Spain as the economic fundamentals remain weak and further delay in advancing a request would probably be taken by financial markets as a sign of political impasse," wrote Barclays analysts Fabio Fois and Philippe Gudin in a research note published Wednesday.

The results of Spain's months-long audit of its banking sector, conducted by consultants Oliver Wyman and Roland Berger, are due on 28 September, according to several media reports, with analysts speculating that the capital needs from the recently-arranged funding scheme from the European Union will likely top €60bn.

Data published earlier this week by the Bank of Spain showed an increase of €960m in non-performing loans - to a record €1.7bn in July - at Spanish banks. The figures could ignite concern that Spain's banks might need more than the anticipated figure to properly recapitalize and create an effect cushion against further property value declines.

RBS estimates capital needs of around €134bn over the next three years.