By Paul Day
MADRID (Reuters) - Spain's borrowing costs are set to rise by more than a percentage point at an auction of three- and five-year bonds on Thursday, with markets watching for signs that its troubled banks are losing their appetite for the country's debt.
The sale is the first since Standard and Poor's cut Spain's credit rating by two notches to BBB+ last week and follows data showing the economy has slid into its second recession since late 2009.
Spain has jumped to the forefront of the euro zone debt crisis due to concern over its public deficit and shrinking economy and pressure is growing for a plan to recapitalize its banks, which are burdened with bad debts from a property market crash.
"Spanish fundamentals remain a concern, as does the lack of international engagement at recent auctions. However, in the near-term such factors should not necessarily preclude a relatively smooth auction," said Peter Goves at Citi.
The treasury is aiming to issue between 1.5 billion and 2.5 billion euros ($2 billion-$3.3 billion) of bonds, maturing on July 30, 2015, January 31, 2017 and July 30, 2017.
Three-year bonds were yielding around four percent while five-year benchmarks were around 4.7 percent on the secondary market on Wednesday, more than a percentage point higher than when they were last sold earlier this year - a good indication of the premium the government may have to pay at the auction.
"That the yields will rise is a given. What will be interesting is whether the domestic banks continue to buy into the auctions or if they're starting to reach their limit," strategist at BNP Paribas Ioannis Sokos said.
The relatively small target amount at the auction, after a heavy issuance program in the first four months of the year, would help demand, Sokos said. The Treasury has already sold half of its gross issuance target for 2012.
Spanish banks, virtually cut out of wholesale debt markets after losing billions since a decade-long property bubble burst in 2008, snapped up cash the European Central Bank pumped into the euro zone banking system in December and February, in operations totaling more than a trillion euros.
Recent data from the Bank of Spain suggests that they used a portion of the ECB's ultra-cheap three-year money to buy up high-yielding sovereign debt.
According to the central bank, Spanish lenders held just over 13 percent of domestic debt in November 2011, but that total soared to almost 30 percent by March. Non-residents held almost 56 percent of all Spanish debt in November, but by March, that proportion had fallen to 38.8 percent.
"There's a reasonable argument to say that borrowing costs would be a lot higher than they are if the (ECB) mechanism was not in place," said Mark Miller, European economist at Capital Economics.
"The further you move into this year and early next year, debt servicing costs might easily become a significant issue and increase the chances that Spain will need some kind of bailout in the future."
After a brief honeymoon period for the new conservative government, fears have grown that Prime Minister Mariano Rajoy will not be able to shrink one of Europe's highest public deficits despite a slew of savings, cuts and market reforms.
Property prices are still falling and some economists say the government may eventually be forced to refinance the banks with public money, putting further pressure on its coffers, or apply for international aid.
(Additional reporting by Nigel Davies, editing by Mike Peacock and Philippa Fletcher)