Italian yields fall on cautious optimism before confidence vote
* Italian bonds rise but lag some peripheral peers
* Trade seen range-bound before Italy's confidence vote, ECB
* Portuguese bonds outperform low-rated debt
By Ana Nicolaci da Costa
LONDON, Oct 1 (Reuters) - Lower-rated bonds rose on Tuesday as investors grew more optimistic before a vote of confidence in the Italian government, but Italian bonds lagged the rise, suggesting investors were still nervous.
Dissent within former premier Silvio Berlusconi's party on Monday raised expectations among investors that the government could survive, but even if it does prospects for stability and reform in Italy look more fragile than ever.
With the possibility of an imminent Italian election averted, however, low-rated debt rose and safe-haven German bonds fell as investors shrugged off for now the U.S. government's first partial shutdown in 17 years.
"In the short-term, Italian debt (prices) are likely to underperform their peers, underperform Spain. I would say a widening of the spreads is the most likely scenario," said Elwin de Groot, senior market economist at Rabobank.
Ten-year Italian government bond yields fell 4.4 basis points to 4.53 percent and Spanish equivalents were 9 basis points lower at 4.21 percent.
On Monday, Italian yields retraced a sharp rise after Reuters reported that as many as 20 senators from Berlusconi's centre-right party are ready to form a breakaway group unless he backs down on plans to bring down the government.
"There is some optimism that some sort of majority will prevail in Italy after these so-called 20 senators announced they may vote with Letta and not bring the government down tomorrow," one trader said. But he said there were still doubts in the market about whether the government would survive.
Portuguese bonds outperformed, with a second trader citing talk of a big buyer late on Monday. Ten-year Portuguese yields fell 25 bps to 6.59 percent, while 10-year Irish yields fell 6.2 basis points to 3.83 percent.
"There was a big buyer late last night, so it's an overspill from that," a second trader said referring to Portuguese bonds.
A third trader said talk of another long-term refinancing operation, after European Central Bank President Mario Draghi flagged that possibility last week, could also be helping.
The ECB meets on Wednesday and is expected to stick with its accommodative monetary policy.
"I think Portugal looks cheap, it's been knocked around a lot over recent months and there is value there," Padhraic Garvey, head of investment grade strategy at ING said.
"We have seen some fast money look at Portugal, we have also seen some strategic long-term holders look at Portugal. Not much (has) changed in terms of your typical conservative asset managers, they are still clear of Portugal."
Ireland's debt agency said on Tuesday it has decided not to issue any more bonds this year, forgoing the chance to demonstrate its access to markets as it has plenty of cash on hand.
Analysts said debt markets showed a muted reaction to the U.S. government shutdown because it was expected to be temporary and because markets had already priced it in to some extent.
Lawmakers could not break a political stalemate, raising fresh concerns about whether Congress can meet a crucial mid-October deadline to raise the government's $16.7 trillion debt ceiling and avoid default.
German Bund futures fell 33 ticks to 140.17 but analysts said the backdrop was broadly supportive for safe-haven assets and they could still rise going forward.
"That (muted market response) is a sign that the market has on the one hand already priced in the negative economic impact of the government shutdown but obviously they are not pricing in, at least at this point, the consequences of a failure to raise the debt ceiling," de Groot added.