EURO GOVT-Bunds up as peripheral downgrade fears mount

* Bunds gain on safety bid from riskier peripherals

* Irish, Portuguese bond spreads at euro life highs

* Worries about contagion, downgrades

By George Matlock

LONDON, Sept 28 (Reuters) - Fears of rating downgrades in peripheral euro zone countries mounted on Tuesday, driving investors into German government bonds as concerns over a two-speed recovery in Europe resurfaced.

Bund prices scaled a three-week high after German, French and Italian consumer morale came in stronger than forecast, though traders focused more on worries about the banking sector and wider concerns about peripheral sovereigns ECON.

"Everyone is looking for where the next contagion among the peripherals will come from after Greece," Charles Morris, head of absolute return at HSBC Global Asset Management said.

"We are taking a risk-free approach and will not buy peripherals at all unless they go formally distressed (into default) when they become interesting again. We have a large cash position and if we are buying anything it is one-to-two year German debt," he added.

Leading laggards were Ireland and Portugal, whose outright 10-year bond yields rose by more than 18 basis points versus a four basis-point fall by 10-year Bunds to 2.23 percent, around a three-week low IE10YT=TWEBPT10YT=TWEBDE10YT=TWEB.

That led Irish and Portuguese spreads over German Bunds to widen to fresh euro zone lifetime highs. [ID:nLDE68R0C8] [ID:nLDE68R0JS] Standard & Poor's estimate that Ireland will have to pour 35 billion euros into Anglo Irish Bank [ANGIB.UL] looks increasingly realistic and any amount beyond that could trigger rating downgrades, an analyst from the rating agency said on Tuesday. [ID:nWLA3971]

A finance ministry spokesman reiterated Ireland would not default on its obligations to senior bondholders in Anglo Irish Bank. [ID:nDUB003252]

The five-year credit default swap, a gauge of the cost of insuring a sovereign's debt against default, hit a record high of 519 bps, according to monitor CMA. [ID:nLDE68R0GY]

Although Spanish 10-year yields rose a comparatively modest three basis points ES10YT=TWEB, worries continued to surround the fourth largest euro zone economy.

The modest move in Spanish spreads came after a 60-bps spread widening since mid-July.

Spain could lose its final triple A rating on its debt this week, but markets may only move sharply if Moody's decides to cut it by more than one notch or place a negative outlook on the country.

Moody's put Spain under a three-month review at the end of June, with the threat of cutting its rating by two notches. [nLDE68Q0TH]

By 0850 GMT, the December Bund future FGBLc1 was up 18 ticks on the day at 131.69, having earlier it a three-week high of 131.99.

The two-year German Schatz yield DE2YT=TWEB was down 0.5 bps at 0.726 percent.

MORE SPREAD WIDENING POSSIBLE

"(Peripheral yield) spreads have the potential to widen against core German paper today because the debt crisis remains the focus," a debt trader in London said.

The forward-looking GfK consumer sentiment survey, released at 0600 GMT showed German consumer morale is likely to rise in October to its highest level since May 2008, lifted by expectations the economic recovery will lead to higher incomes.

The trader said investors would brush aside buoyant euro zone data because the bigger threat to assets was the risk of crisis contagion.

Later in the session, investors will focus on whether U.S. consumption is helping to support the world's largest economy when data is released at 1400 GMT <ECON/US>.

Economists polled by Reuters forecast U.S. consumer confidence dipped to 52.5 in September.

(Editing by John Stonestreet)