* If Spain seeks aid, Italy could be next in focus
* Spanish, Italian funding costs seen falling
* Italy seen underperforming Spain if aid sought
* Premium of Spain over Italy could disappear
LONDON, Sept 27 (Reuters) - Italian government bonds risk being thrown back into the spotlight of the euro zone debt crisis once Spain decides to request aid and secures central bank support for its debt.
A partial bailout for Madrid would probably trigger the European Central Bank's bond-buying plan, lowering Spain's borrowing costs and increasing investor appetite for riskier assets in general, including debt issued by Italy.
But Italy could then return to the forefront of market concern as the next weak link.
"The risks increase that you will get a contagion into Italy," said David Keeble, global head of fixed income strategy at Credit Agricole.
With the crisis still unresolved, any temptation to sell lower-rated debt may be focused on the Italian market, which is liquid but would lack the ECB backstop.
"You can't short Spain because you have got the ECB trading in the other part of the trade in unlimited size so Italy takes the brunt of the selling," Keeble said.
Both Italy and Spain are in recession but the former is seen as in better fiscal shape. Italy's budget deficit is smaller than that of Spain, which is struggling with an overextended banking system and regional debt problems.
However, the Italian government said this month the economy would contract twice as much in 2012 as previously forecast. Analysts say the bleak growth outlook and an uncertain general election due by April could fuel contagion.
Technocrat Prime Minister Mario Monti, who enjoys the confidence of investors and European partners but lacks his own political base, gave the clearest indication so far that he is prepared to stay on after the election if there was no clear winner.
"Should there be the circumstances in which (Italian parties) believe I could serve helpfully after the elections, I will be there," he told the Council on Foreign Relations in New York.
A renewed loss of confidence in Italy' fiscal position and, if pressure mounts on yields, on its ability to fund itself would be dangerous for the euro zone. Italy is the region's third largest economy and too big to be rescued.
Spain's borrowing costs over ten years have fallen 180 basis points since the ECB vowed in late July to do whatever it takes to preserve the euro and later unveiled the conditional bond-buying programme. Italian funding costs are down 150 bps over the same period.
Funding costs would probably fall for both countries after Spain requested a bailout. The spread 10-year Spanish and Italian debt offer over Germany could narrow to 300 bps from 457 bps and 372 bps respectively, said Martin Harvey, fund manager on the fixed income desk at Threadneedle Investments, which has over $116 billion of assets under management.
The yields last reached parity in March when Spain announced a bigger than expected 2012 budget deficit target and investors started demanding more to hold Spanish than Italian debt.
PLAYING WITH FIRE
After a Spanish rescue request, traders might be tempted to sell Italian to buy Spanish bonds, on the view that Spain will benefit from the ECB scheme first, analysts said. This could be focused in short maturities, within the scope of the ECB plan.
"As Spain is strong-armed into a bailout and once it does accept a bailout, I would go long Spain short Italy because the question then is what happens to Italy?," said Richard McGuire, senior fixed income strategist at Rabobank.
The rise in Italian yields resulting from this trade could pile additional pressure on Rome to seek financial aid.
Economy Minister Vittorio Grilli said on Wednesday that Italy has no intention of seeking help from the European Union bailout fund or the ECB.
Helen Haworth, head of European interest rate strategy at Credit Suisse, said European policymakers should aim to ensure Italy can avoid a bailout.
"Because if you start thinking about who is paying for it and who is going to be supporting it, then you start looking at who is next and quite quickly you will end up looking towards France and nobody wants that to happen," she said.
Harvey said the promise of ECB intervention had prompted his fund to resume investment in short-dated Spanish bonds in the past month for the first time this year.
But the ECB would need to buy Spanish paper aggressively for Threadneedle to add to their holdings of Italian bonds.
"If Spain asks for a bailout and it looked like the ECB was being sufficiently aggressive in order to bring yields down then we would be more comfortable holding, I think, an overweight position in Italy rather than where we are right now which is around neutral," Harvey said.
Past attempts by the ECB to curb borrowing costs are not reassuring. Bond buying through the now defunct Securities Markets Programme failed to bring Italian and Spanish yields down sustainably.
Some believe the ECB's strong language suggests this time will be different. But the euphoria related to central bank action is already fading and Credit Suisse's Haworth said the longer it takes for the bond-purchases to be activated, the greater the risk it has only a muted impact.
"One of the risks is that by the time Spain asks, the market's perception of this being the bazooka that was asked for is no longer the case. In that context, I think Italy can sell off," she said.