UPDATE 1-Italy's one-year borrowing cost lowest for three years
* Yields fall to 0.864 pct from 1.46 pct a month ago
* Treasury sells planned amount of 8.5 bln euros
MILAN Jan 10 (Reuters) - Italy paid the lowest costs in three years to raise funds through one-year bills on Thursday with investors undeterred by a bitter election campaign in the heavily indebted country.
The relatively high yields offered by Italian and Spanish paper are still drawing investors, especially given the European Central Bank's offer to buy bonds if euro zone countries sign up for conditional help.
The Italian treasury sold all the planned 8.5 billion euros ($11 billion) of bills paying a yield of 0.864 percent, the lowest since January 2010. It paid 1.46 percent on a similar bill at a mid-December sale.
Debt markets for such countries have rallied in the first week of 2013, with the risk premium for 10-year Italian BTPs compared with equivalent German Bunds falling below 270 basis points on Thursday, its lowest level in more than 16 months.
"Demand was good, the yield has fallen below the levels seen last night and there was no concession at the auction. It's a positive moment for markets and Italy is benefiting from that together with other peripheral countries," said Giuseppe Maraffino, a strategist at Barclays.
"Investors are hunting for higher returns, and with core euro zone paper offering yields just above zero are lured by the yields of peripheral debt."
Returns on German one-year paper stood at around 0.18 percent on Thursday.
Just minutes before the Italian sale, Madrid easily placed 5.8 billion euros of bonds, well above its target range and also paying lower yields.
In a report issued late on Wednesday rating agency Standard & Poor's said its base case scenario was that the elections in Italy would allow pursuit of the current policy path, a view that analysts say is reassuring investors.
"In our view, a victory of populist and anti-European forces in Italy would have a detrimental effect on the corrections taking place in the euro zone, especially if euro zone membership itself were to be put in question," S&P said.
"We note, however, that the polls do not currently signal such an outcome as likely."