NEW YORK (MarketWatch) — The grand deal struck last month to keep Greece from default had an unintended consequence that’s encouraged investors to dump the debt of Italy, Spain and other countries, causing yields to spike, bond analysts say.

“That’s why you saw Italian yields jump,” said Don Quigley, co-portfolio manager of the Artio Total Return Bond Fund BJBGX, -0.13% JBGIX, -0.14% . “If everyone that thought they were hedged with CDS (credit-default swaps) thinks they’re now worth nothing, they have to sell.”

The Greek deal “was very short-sighted,” he said.

The European Union’s Oct. 27 deal involved an agreement with international banks that would take a “voluntary” 50% haircut on the value of their Greek bonds. Read more on Greek bond deal.

The industry body in charge of setting standards on credit default swaps, or CDS, determined that if such a deal was deemed voluntary as it was structured, it wouldn’t trigger a payout on the CDS. Read more on the International Swaps and Derivatives Association's comments.

The move made sure banks didn’t have to pay out a lot on the CDS on top of losing money on the bonds. But it also made international investors question the effectiveness of holding these derivatives as a hedge against the sovereign bonds. Without the hedge, there was more pressure to dump bonds.

The plan “raised the issue of whether the CDS market any longer provides a realistic way of hedging European sovereign or European bank credit risk,” said Christopher Wood, equity strategist for CLSA in Hong Kong, in commentary last week.

“The widespread view in America is that it does not, even if this technical issue may not have caught the attention of the Eurocrats who came up with the Greek package,” he added.

The European Union’s plan for Greece isn’t a done deal: Banks, as represented by the Institute of International Finance, continue to discuss the deal and hope an agreement can be struck by the end of the year. And of course Greece threw its own wrench in the works by considering a public referendum, which further spooked investors from holding sovereign debt.

This week, Italy’s 10-year yields (10YR_ITA) jumped well over 7%, a key level considered unsustainable, from 5.77% when details of the EU deal came out Oct. 27.

Spain’s 10-year yields (10YR_ESP) trade at 6.35%, up from 5.31% less than a month ago.

Europe's week ahead: Spain

At the same time, the CDS spreads on several countries jumped. The debt of France, Belgium and the Netherlands have also come under attack in recent days as more investors worry about the futility of CDS as a hedging tool.

The spread on Italy’s five-year CDS rose to about 529 basis points, or 5.29 percentage points, from 400 basis points in late October, according to CMA Datavision. A CDS spread of 529 basis points means it would cost $529,000 each year to insure $10 million of Italian debt against a credit event for five years.

The selloff of European sovereign CDS, and the underlying bonds, stems from the deal struck in late October, which included a “voluntary” Greek restructuring of its debt owned by the private sector – which mostly means debt held by European banks.

Guarantees provided by U.S. lenders on government, bank and corporate debt in Portugal, Ireland, Italy, Greece and Spain, mostly credit-default swaps, rose by $81 billion to $518 billion in the first half of this year, says CLSA’s Wood in a note, citing the Bank of International Settlements.

That means the CDS holdings of American banks are almost three times as much as their $181 billion in direct lending to those five European countries at the end of June, Wood said. Read Christopher Wood’s money moves.

Ease of trading

As with many derivatives, the CDS market is multiple times bigger than the underlying securities they hedge. That’s because it has been a helpful way to increase or decrease the amount of risk and exposure one has to a credit – in this case a country – without having to buy or sell the actual security, analysts said.

Losing that outlet prompted many investors to just sell their holdings of the bonds, pushing yields up and weighing on the euro earlier this week. Read about euro falling as bond yields jump.

“Some degree of uncertainty about how much protection you have in the position means you’re probably better off selling the name, and that’s causing some contraction in the investor base,” said Stewart Hall, a senior currency strategist at RBC Capital Markets.

Lots of traders preferred using CDS as a hedge, instead of, for example, shorting the actual security, because they were often more liquid and easier to trade, said Tim Rice, senior vice president of taxable fixed income trading at D.A. Davidson.

Now, without that hedging option, traders may simply demand a higher yield from debtors – exactly what Europe’s deal was intended to avoid.

“Going forward, people are going to demand a higher yield on other sovereign credits, especially in the euro zone, because they can’t be sure their assumptions in terms of risk management are the same as they were previous to the Greek deal,” he said.