Speculation a far-reaching policy response to the eurozone debt crisis could be in the offing is prompting banks to devise strategies that mitigate the risk of a rapid sell-off in safe-haven German debt.

As Spain edges closer to asking for a banking bailout and Germany pushes for landmark steps towards full fiscal union, banks are working on ways to hedge against a swift reversal in the recent clamor for safe, low-risk assets.

Demand for German bonds has surged to record highs in recent weeks as investors sweat over the risk that Greece may quit the euro and Spain's banking problems could shut off its access to funding.

Reuters sources said Spain would request European aid to help recapitalize its banks this weekend, aiming to seal a deal before Greek elections on June 17. A Spanish government spokeswoman said she was not aware of any pending announcement on a bank rescue.

Allowing the eurozone's bailout funds to pump cash directly into Spanish banks, and concrete progress from EU leaders towards a risk-sharing fiscal union may be enough to win back some investor confidence, market participants said.

This may see more investors shifting out of Germany and into the region's other highly-rated countries' bonds, which offer a higher yield, though not immediately into peripheral debt.

Even though many in markets remain fundamentally skeptical that the eurozone will escape its debt crisis any time soon, at such extreme levels a change in sentiment could quickly snowball as investors sell to lock in profits and close out bets on a further safe-haven rally.

While strategists say it is too soon to actively sell Bunds, banks are recommending way to protect against the risk of tumbling prices, using curve-steepeners, and relative value trades into French, Dutch and Belgian debt.

Curve Steepening

Short-term German bonds are the assets of choice when tensions rise because they are safe and easily tradable. But with two-year yields at, or even below zero, the search for safe havens has boosted demand for longer-dated German debt, flattening the yield curve.

That move may have reached its limit, said Michael Leister, strategist at DZ Bank in Frankfurt, who recommended clients close out curve-flattening bets that have profited as the debt crisis has worsened.

"A further escalation of the debt crisis will increase the risk of a comprehensive policy intervention, as EMU officials are still determined to keep the euro alive, at least for the time being," he said. "In such a scenario, the belly and long-end of the German curve would suffer the most."

Rabobank strategists said that a game-changing policy shift would drive 30-year German yields, which fell below 2 percent for the first time in May, higher and re-steepen the curve.

A payer swaption — an option to enter a swap contract — on 30-year rates would benefit under this scenario, said Rabobank strategist Lyn Graham-Taylor.

"We've been suggesting swaptions — basically a way to set yourself up for a steepening of the curve," he said.

The trade involves purchasing an option contract giving the right to pay the current low interest rates while receiving a floating rate that changes over time. If rates rise in the future, the option becomes valuable — or "in the money".

Current prices show a one-year option to pay fixed 30-year rates and receive floating payments would be "in the money" if swap rates — tightly correlated with German yields — rose much above 2.09 percent. Thirty-year swap rates were last at 2 percent.

Core Club

Some of the eurozone's less-risky bonds could also benefit if investors unwind positions in "core" German debt.

The region's "semi-core" of Belgium, France, Austria and the Netherlands all offer a higher yield than German debt, and may be attractive as a first step away from the shelter of Bunds.

"This could be part of a natural hedge. If Europe moves forward, the very safe bet would be that core Europe stays together," Commerzbank strategist Rainer Guntermann said.

Investors hunting for a higher yield have already begun switching into these bonds as German yields fall to unattractive levels, but the trend could still have further to run, he said.

However, for all but the most speculative investors a full-blown move into the peripheral debt of Spain and Italy was seen as too risky given the slow pace of European policymaking and myriad obstacles blocking the path of reform.

The time to buy back into riskier markets and cut back on Bunds would be when the policy response actually arrived, said Nicholas Gartside, International Chief Investment Officer for Fixed Income at JPMorgan Asset Management

Gartside said his fixed income funds carried less Spanish debt than their benchmark, which acted as insurance again a failure to deliver on the policy front.

"I think what you have to wait for is the actual response. Historical experience tells us you get to the cliff, look over it and then you get some kind of response. Who knows if we're there yet?" he said.