As Spain's recession undermines efforts to cut the deficit, the risk of bank losses is keeping 10-year yields at almost 6 percent as investors speculate the government will be forced to bail out the financial system.

The nation's 10-year borrowing costs have climbed about 70 basis points this year as Prime Minister Mariano Rajoy struggles to convince investors he can control public finances amid soaring unemployment and a contracting economy. Banks threaten to disrupt the premier's efforts as bad loans reach the highest levels in almost two decades.

"Spain is likely to need support in both the banking and government sectors," said Jamie Stuttard, head of international bond portfolio management at Fidelity Investments, which has $1.2 trillion of assets. "Government bond market developments hold the key."