Beware the Bondholder: Debt Auctions in Spain, Portugal Hit Markets

Europe's sovereign debt markets were back in focus Wednesday after poorly-received bond sales from Spain and Portugal lifted borrowing costs and hit stock markets across the region and the ECB kept its benchmark lending rate unchanged as it awaits a recovery.

Benchmark 10-year government bonds yields for Spain, Italy and Portugal were all higher in an active trading session in Europe, which followed a grim series of service-sector data from around the region suggesting the Eurozone is unlikely to avoid recession this year.

A second reading of the the Markit Purchasing Managers' Index for March was measured at 49.1, a mild improvement from the first tally but still down from February and firmly below 50 - the level at which most economists say marks the difference between expansion and contraction.

The single currency fell to a two-week low against the British pound after the reports, while the broadest measure of equity market performance, the FTSE Eurofirst 300, slid 1.77 percent to trade at 1,054.00 by 4:00pm London time - a 2012 low.

Spain's €2.59bn bond sale - smaller than the government would have liked - was first out of the gate after the data. Borrowing costs for the two separate sales (notes maturing in 2015 and 2020) were significantly higher than the previous sale on 1 March and suggested investors were yet to be convinced by the €27bn in spending cuts unveiled by Prime Minister Mariano Rajoy in his "very, very" austere budget last week.

"It's going to be a quite bad year for Spain," Ashok Shah, chief investment officer at London & Capital told CNBC Europe's "Worldwide Exchange" programmed Wednesday. Shah expects a 3 percent contraction for Europe's fourth-largest economy this year "and more contraction next year as well."

Spain's government bond yields rose immediately after the report Wednesday, with the benchmark 10-year note trading 25 basis points (bps) higher at 5.70 percent by the end of the European trading session.

Credit default swaps, a derivative used by bond holders to protect themselves in event of default, were also higher after the sale. Five year CDS prices rose by 20 basis points to 457bps by session close. This means and investor would have to pay €45,700 each year for five years to ensure €10m Spanish bonds against default, the highest since last November.

The country's debt management agency said Tuesday it will likely make fewer long-bond sales this year as it seeks to fund the government's budget deficit, it said today. The move will reduce the average maturity of outstanding debt to 6.2 years from the current 6.4. Around 45 percent of the agency's €37bn 2012 funding target has been completed.

Italy's benchmark 10-year notes, known as BTPs, were trading around 10 basis points higher at 5.35 percent.

Portugal's debt sale fared little better. The €1bn auction of 18-month "treasury bills", the longest instrument from the country's debt management agency since the EU bailout last year, were sold at an average yield of 4.537 percent, roughly three times the 10-year borrowing costs of Germany and France. Portugal's 10-year bonds trade at a yield of 11.88 percent.

The data - and the market reaction - were reflected in statements from European Central Bank President Mario Draghi in Frankfurt Wednesday.

"The remaining tensions in euro area sovereign-debt markets are expected to dampen economic momentum," Draghi said. "We continue to expect the euro-area economy to recover gradually in the course of the year."

The ECB held its monthly rate decision a day earlier than usual, owing to the Easter holiday observances around the Continent this weekend.

The Bank kept its benchmark lending rate unchanged at 1 percent even as Draghi said he sees "upside risk" to its inflation outlook, which he expects will stay above 2 percent for most of the year.