YIELDS ON Irish Government bonds fell again yesterday, maintaining this week’s strongly positive trend.

This was the result of improving investor sentiment following last week’s stress testing of 91 European banks.

Both AIB and Bank of Ireland, the two largest Irish banks, passed the tests.

If Government bond yields stabilise at current levels, or fall further, the cost of future borrowing by the State will be significantly lower than it has been recently.

Since Monday, increased demand for Irish Government debt has pushed the yield (effectively, the rate of interest) on the benchmark l0-year bond down sharply.

Yesterday it finished below 5 per cent, down from over 5.4 per cent at the start of the week. This is close to the average recorded in the second half of 2009 – a period of relative calm before the eruption of the euro zone sovereign debt crisis in early 2010.

The fall in the yield recorded since Monday is the second largest decline over a four-day period since Irish Government bond yields rocketed in early 2009 on the announcement that Anglo Irish Bank was to be nationalised.

However, research published yesterday by the credit rating agency Standard Poor’s highlights the difficulties facing Irish banks. It notes that these difficulties could push up the cost of borrowing for the Government.

The agency sees a “two-tier” bank funding market emerging, with banks in the peripheral euro zone countries facing higher funding costs, either because they are weak or because the credibility of government support has been eroded. In the case of Ireland, Greece, Portugal and Spain, both of these factors are at play.

The risks are specifically centred on the banks’ abilities to repay borrowings of various kinds which fall due in the second half of 2010 and beyond. From the early months of 2010, concerns about the solvency of European banks caused investors to seek a greater risk premiums when lending to financial institutions, driving up the cost of raising funds.

AIB and Bank of Ireland, which are among Europe’s 50 largest banks according to SP, are also among the most vulnerable. Its ratings for both banks are thus among the lowest of the 50, with only five institutions rated below Ireland’s big two (one from Portugal and two each from Greece and Germany).

AIB is rated “A minus” and is on negative watch, which means that SP is likely to downgrade it if it does not recapitalise as planned. Bank of Ireland shares the same rating, but is viewed as being less vulnerable and is therefore not on negative watch.