* 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 Emelia Sithole-Matarise and William James LONDON, Feb 28 Italian bond prices rebounded 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. Nevertheless, they underperformed southern European peers Spain and Portugal as the political crisis in the euro zone's third-biggest economy deepened after party leaders ruled out the most likely options to form a government. That raises the chances another vote will need to be held. The ECB's longstanding promise to buy bonds issued by struggling states if needed has helped to limit the selloff in higher-yielding debt, although some in the market question how the scheme could be activated for Italy if it does not have the credible pro-reform government required. Italian 10-year bond yields were 8 basis points lower on the day at 4.74 percent while low-risk German Bund futures dipped 10 ticks to settle at 144.99. "We have a bit of a rally now in Italy because spreads went out quite a lot to begin with. I think the guys that have bought into that rally will begin to take profit and I see Italian spreads widening back out again," said Padhraic Garvey, head of investment grade strategy at ING. "But if you are willing to forget the noise and just go with the bigger picture, yes, buy now (and) close your eyes, betting it will be OK by year end." 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 seen in July last year, before the ECB first hinted it might buy bonds. For some investors, a potential coalition between Italy's centre-left Democratic Party and the anti-establishment 5-Star Movement - though rejected by the latter's leader Beppe Grillo - was still likely. If such a government were to prove unstable, however, it could trigger sharp swings in Italian asset prices. Italian bond yields could rise 50-100 basis points in that scenario, said Mirko Cardinale, head of strategic asset allocation at Aviva Investors. "There is also a real possibility of a 'Sunbathing (care-taker) government' and fresh elections, which could lead to heightened volatility in bond and equity markets, with bond yields moving up 100-200 basis points," he added in a note. SHRINKING PREMIUMS Spanish bonds outperformed Italy for a ninth day running, with analysts pointing to signs Spain was having some success in reining in its spending and borrowing. 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 17 bps at 5.10 percent, while the premium investors demand to hold Spain over Italy touched 36 bps - its narrowest since May last year. 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 slightly up on the day at 1.46 percent but close to two-month lows hit on Wednesday at 1.42 percent.