Greek bond prices posted a drastic decline Thursday as traders began betting a debt default is inevitable, even if the country receives a massive bailout.

The Greek bond market is now priced for a "catastrophic event," says Sebastien Galy, senior foreign-exchange strategist at BNP Paribas.

Greece's woes helped sink the euro to an 11-month low before the common currency recovered some of its losses.

Although conditions in the Greek bond market have generally been deteriorating over the past several weeks, Thursday's session saw an especially steep decline in short-term debt prices. As a result, the yield on Greek two-year notes jumped to more than 12% from 8.3% Wednesday, according to Tradeweb.

At those levels, the prices are suggesting that "even if [Greece] finds a solution, if you buy two-year bonds, you may not be getting all your money back," says Mark Schofield, global head of interest-rate strategy at Citigroup in London.

Meanwhile, yields on 10-year Greek bonds rose to 8.92%, almost six percentage points over comparable German debt. That gap is the widest since Greek joined the euro zone. Just two weeks ago, that spread stood closer to four percentage points.

The backdrop for the selloff was still more bad news for Greece. The European Union's statistical authority said Greece's 2009 budget deficit was worse than had been previously reported, and politicians in Germany ramped up their opposition to a Greek bailout.

Meanwhile, Moody's Investors Service downgraded Greece's debt rating and warned that additional cuts could be on the way.

The woes in the Greek bond market also are spilling over to other European nations with fiscal problems, such as Portugal, Spain and, to a lesser extent, Italy. Traders say the selloffs in those markets to some degree reflect a sentiment that bond prices in those markets hadn't been reflecting the poor fundamentals of those countries.

For much of April, even as the Greek bond market began to collapse, prices on the other Mediterranean countries' debt had been relatively stable. On April 1, for example, the gap, or spread, between German and Portuguese two-year debt stood at less than 0.6 percentage point, almost the same as U.S. Treasury debt.

But in the past week, the Portuguese spread has risen sharply, hitting 1.83 percentage points Thursday from 0.83 percentage point a week ago. Spain's two-year spreads widened 0.82 percentage point Thursday from 1.38 percentage points Wednesday.

'We're seeing contagion," says Citigroup's Mr. Schofield, who noted that the impact of Greece was also being seen in a widening between the prices at which bonds could be bought and sold. "I don't think those countries are an immediate default risk to the same extent as Greece … but these are countries where the fiscal backdrop is very poor."

With financial markets focused on the prospect of a debt default by the Greek government, the International Monetary Fund fretted aloud this week about the prospects for a sovereign-debt crisis, focusing on Europe.

In a report this week, the IMF said Portugal, and to a lesser extent Spain and Italy, would be the most likely to suffer from contagion if Greece goes over the edge.

IMF's contagion analysis noted that Ireland, in the line of fire a year ago over its own fiscal woes, would escape the worst of a Greek default. Investors appear to believe Ireland has acted pre-emptively and decisively to get the deficit under control, analysts noted.

To avoid Greece's plight, says Uri Dadush, a former World Bank official now at the Carnegie Endowment in Washington, Italy too should move aggressively to cut its budget deficit by a further 4% of gross domestic product over three years, and engineer a 6% real devaluation through wage cuts and economic reforms.

"I think the broad policy recommendations have general applicability in Spain, too," he said.

On Thursday, the damage from Greece also spread to the currency markets, where the euro slid as low as $1.3257, its lowest level since May 2009. By day's end the euro had rebounded slightly and was changing hands at $1.3314, from $1.3399 Wednesday.

BNP's Mr. Galy says one potential silver lining is that many European banks may have reduced their exposure to Greece.

"Risk managers seem to have hit the panic button on anything that was left," he says. "That's good from a systemic point of view."

Many investors say there are just too many headwinds for Greece to overcome, and that even a bailout won't be an end to the crisis.

"The problem is likely going to come back in 2011 and 2012," says Michael Hasenstab, manager of the Templeton Global Bond Fund. "You get in this vicious cycle, and it's a very difficult situation."

Moody's Investor Services downgraded its rating on Greece's sovereign debt and warned that further downgrades could be in the offing.

The credit ratings agency's move to reduce its rating on Greece to A3 from A2 came after the European Union's statistical authority cast fresh doubt on the accuracy of Greece's financial reports and said the country's 2009 budget deficit–already yawning–was wider than previously thought.

The news sent Greek bonds into a tailspin, with the yield on a Greek 10-year bond nearing 8.7%, and all but dashed any remaining hopes that Greece might borrow afresh from international markets.

The euro also dropped on the news to $1.3257, its lowest level since May 2009.

The global recovery has reached a key transition stage: can corporations take up the spending baton from governments? They’ve got the cash but do executives have the confidence? Doubts about final demand, the strength of the recovery and mounting sovereign risks have so far caused boards to hold back on investment. But with Western households and governments requiring substantial deleveraging, only a revival in corporate spending will safeguard the recovery as stimulus programs wind down.

Corporate spending fell off a cliff during the recession, forcing governments to take up the slack. U.S. nonresidential investment plunged 17.8% in 2009. But companies are generating cash and balance sheets are strong; credit ratings upgrades are starting to outstrip downgrades. U.S. nonfinancial free cash flow is 2.8% of GDP, a near-40-year high, according to Credit Suisse. Debt funding is also cheap and available: average U.S. long-term corporate-bond yields are close to 40-year lows, Moody’s data shows. European credit spreads are likely to tighten further even after last year’s rally, according to Citigroup.

Crucially, investors may now give executives the thumbs-up for spending: for the first time since December 2007, fund managers rank capital expenditure and dividends as higher priorities than deleveraging, a Bank of America Merrill Lynch survey showed this week. Companies are thinking the same way: a survey of over 50 large European companies by Credit Suisse found 63% are now looking to maintain or boost spending in the next 12 months, compared to 27% in the last six months, with cash flowing to new hiring, advertising and IT.

Whether this spending materializes depends on confidence. There are some promising signs. Both in the U.S. and Europe, manufacturing and trade are picking up. Euro-zone exports hit a 15-month high in February and trade within the currency bloc climbed 8% on last year. But the headwinds remain severe. Final demand is largely reliant on Asian and emerging market consumers. Corporations may be squeezed through higher taxes. And if borrowing rises, companies may have to compete with governments for capital.

The fate of the recovery now lies in the hands of corporations. Fear of a double-dip recession that deters corporate spending may yet prove self-fulfilling.