EURO GOVT-Faith in ECB backstop helps Italian bonds recover
* Italian debt rebounds as ECB backstop keeps market calm * Spain outperforms Italy, spread at narrowest since June * Heavy long bias towards periphery creates selloff risks By William James LONDON, Feb 28 (Reuters) - Italian bonds pared recent losses on Thursday as investors took stock of the country's political stalemate, with concerns over possible fresh elections offset by the European Central Bank's bond-buying backstop. The political crisis following indecisive election results in Italy deepened on Wednesday when two party leaders ruled out the most likely options to form a government, raising the chances of a fresh vote. But the ECB's longstanding promise to buy bonds issued by struggling states if needed has helped to limit the selloff in Italian bonds. It was expected to continue doing so over the near term. Italian 10-year bond yields were 7 basis points lower at 4.76 percent while German Bund futures were steady on the day at 145.09. "There will be a risk premium on Italian yields until a new government is formed and we know what they're going to do with structural and fiscal reforms," said Nick Stamenkovic, strategist at RIA Capital Markets in Edinburgh. "But we're not going to see a return to the levels we saw a year ago because the ECB has pledged to use its balance sheet if necessary." Italian 10-year yields have now trimmed around 15 basis points of the 50 basis point rise seen earlier this week. Current yields are well above lows near 4.12 percent hit in January but still lower than the 6.6 percent in July last year before the ECB's first hinted at its bond-buying support. SPAIN OUTPERFORMS Spanish bonds also rallied, outperforming Italy for a ninth day running, with analysts pointing to signs Spain was having some success in reigning in its spending and bringing. The Treasury minister said on Thursday the 2012 deficit was 6.74 percent - missing a European-agreed target of 6.3 percent but within a range that markets will see as acceptable. "If you combine the positive news from Spain on the fiscal side with the uncertainty coming out from Italy you see a shrinking of the spread," said Sergio Capaldi, fixed income strategist at Intesa SanPaolo. Spanish 10-year yields were down 10 at 5.16 percent, while the premium investors demand to hold Spain over Italy touched 37 bps - its narrowest since June last year. Nevertheless, bond markets' risk-hungry start to the year, when investors loaded up on higher-yielding debt from across the region's struggling peripheral states, has left many exposed to further weakness in Italian BTP bonds. The heavy bias this year towards betting on a rise in Italian bonds means that any fall in prices leads to lower profits or even outright losses for investors, giving a strong incentive to sell out quickly if the situation worsens - a potential snowball effect that could benefit German debt. "We continue to maintain a positive view on Bunds, with the view that yields go to 1.25 percent and possibly beyond," one trader said. Ten-year German yields were last at 1.45 percent, flat on the day and holding close to two-month lows hit on Wednesday at 1.42 percent.