Downgrade doldrums dog European bonds

French bond auctions drew solid demand but nervous investors were too focused on downgrades to notice.

NEW YORK (CNNMoney) -- Worries about a French downgrade persisted even as several bond auctions drew solid demand Thursday.

"The markets are extremely spooked," said Tommy Molloy, chief dealer at FX Solutions in Saddle River, NJ. "Its not a question of if there's a French downgrade, but when. It seems like inevitability."

The French auction of about € 7.9 billion on bonds included more than € 4 billion worth of 10-year bonds, with a yield of 3.29% and a bid-to-cover ratio of 1.64%.

That's not too shabby, considering the 10-year closed at 3.35% on Thursday. But anxiety continues to dog European bond markets.

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"Anything that can be interpreted badly is being interpreted badly," said Molloy. "Even the French auction, which didn't go that badly, in isolation would be considered a fairly neutral auction."

Considering the downgrade threat hanging over France's proverbial head, Molloy said the auction results are "insufficient to stem the negativity that's out there."

That could spell further unrest and volatility in financial markets around the world. Hundreds of billions of euros worth of European bonds are set to hit the auction block in the coming months as nations, including Italy and Spain, look to raise cash by refinancing existing debt.

On Wednesday, Germany also sold about € 4 billion of the € 5 billion in 10-year bonds that it brought to auction. Even though less was sold, the results were considered "satisfactory," said Nick Stamenkovic, fixed income strategist in RIA Capital Markets Edinburgh, Scotland.

That may be partly due to the fact that German bunds, backed by the strongest economy in Europe, are considered the gold standard of stability.

The 10-year German bond closed at just over 1.8% on Thursday, while Wednesday's auction drew an average yield of 1.93%. That's slightly below the previous month's auction yield of 1.98%, which drew extremely weak demand.

But it appears the appetite for German debt has returned.

"We always thought that the weakness following the poor November auction was unjustified," said Jack Kelly, European fixed interest fund manager for Standard Life Investments in Edinburgh. "Germany is still the standout liquid eurozone safe haven market."

Europe still a pain for investors

The downgrade anxiety in Europe has also taken a toll on equity markets. London's FTSE (UKX) dipped 0.8% in Thursday trading, while the DAX (DAX) in Frankfurt slipped 0.3% and the CAC 40 (CAC40) in Paris dropped 1.5%. Also, the euro lost ground to the U.S. dollar, dipping just under $1.28 -- its lowest level since September 2010.

"One of the key factors behind the poor sentiment towards the euro is the challenge posed by the sovereign and bank refunding needs this year as rating downgrades loom around the corner," wrote Brown Brothers Harriman currency strategist Marc Chandler in a client note.

Last month, Fitch Ratings put France's AAA-credit rating on watch for a possible downgrade. Earlier that month, Standard & Poor's said it was reviewing 15 members of the eurozone for potential downgrades, including France and Germany.

"French bond yields are rising as markets continue to fret about the Paris government's ability to pay its debts," said Ranvir Singh, chief executive of the market analysis provider RANsquawk in London. "There is now broad consensus that France is the AAA-rated eurozone economy most likely to be downgraded by Standard & Poor's later this month."