* Spanish borrowing costs at lowest since early April * Bunds fall to three-week low as Moody's decision weighs * Pick-up in 2-yr German yield lures investors at sale By Ana Nicolaci da Costa LONDON, Oct 17 (Reuters) - Spanish government bond yields fell to their lowest since early April on Wednesday after Moody's kept Spain's investment grade rating, removing an immediate threat to the euro zone's fourth-largest economy. Moody's affirmation of Spain's Baa3 rating with a negative outlook eased widespread fears the country would be cut to "junk", which would have left its bonds vulnerable to forced selling as they were shifted out of benchmark indices. It kept pressure on Madrid to seek aid, however, saying the rating was underpinned by expectations Spain will seek euro area and European Central Bank support. The rating agency's decision dented appetite for safe-haven German government bonds in the secondary market but there was ample demand at a sale of two-year German paper. "We have a 'risk on' mood after the Moody's affirmation of Spain's rating, but one of the key reasons why the auction was so well covered was the spike (higher) in yields clearly in positive territory," Michael Leister, senior fixed income strategist at Commerzbank, said. Spanish yields fell sharply, testing the lower end of ranges that have held for weeks on uncertainty over when Madrid will seek a bailout deal that would allow the ECB to buy its bonds. Expectations it will do so have made investors reluctant to sell the country's debt. Spain's 10-year bond yield fell 26 basis points to 5.55 percent, its lowest in over six months. Two-year yields fell below 3 percent for the first time in a month and stood 28 bps lower at 2.9 percent. Italian bonds rose in tandem with Spanish ones, with 10-year yields hitting their lowest since March at 4.82 percent. They were down 10 bps at 4.84 percent. "It seems we are close to breaking the trading range that has been in place since September. For me, to have a real break, we need to go below 5.50 percent (on the Spanish 10-year)," said Alessandro Giansanti, senior rates strategist at ING. GERMAN APPETITE Germany's 4.2 billion euro sale of two-year debt on Wednesday drew strong demand as a recent rise in yields from zero lured investors into safe-haven German debt, even as the Moody's decision fuelled risk appetite. The auction received bids worth twice the amount allotted to investors, compared with 2.1 times at the previous sale and a 1.87 average for 2012. "It was a very strong auction," Artis Frankovics, strategist at Nomura said. "On a relative value basis the bond was attractive... and also the collateral situation hasn't changed at all, a shortage of high-quality collateral, and the Schatz actually fills this gap very nicely." In the secondary market, two-year bonds yielded 0.08 percent, while 10-year yields were 5 basis points higher at 1.59 percent. German Bund futures fell 58 ticks on the day to 140.19. On Tuesday, it saw its biggest one day fall in more than a week on talk Spain may be close to seeking financial help. Analysts did not think the recent sell-off was the beginning of a bear trend for the Bund given major economies remain sluggish and rate policy accommodative, while uncertainty regarding the debt crisis persists. "I would not be too negative on the Bund," Piet Lammens, strategist at KBC, said. "We are still in the same longer-term pattern where bond yields will stay rather low, so we might move up in yield terms maybe to 1.70 to 1.80 (percent) but not much more." Moody's decision not to downgrade Spain gives a favourable backdrop for an auction on Thursday at which Spain will test market appetite for three-, four- and 10-year paper. "That will play in favour of more demand also from foreign investors at tomorrow's auction, so there will be more support for the 10-year auction," ING's Giansanti added. Spain sold more short-term debt than planned on Tuesday at slightly lower rates than a month ago, attracting investors on expectations that a sovereign aid request could be near.

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