By Emelia Sithole-Matarise
LONDON, March 4 (Reuters) - Spanish yields fell back to 8-1/2-year lows on Tuesday as investor alarm over Ukraine eased somewhat and the market refocused on expectations that the ECB might loosen monetary policy further as soon as this week.
Spanish and Italian bonds outperformed German and other top-rated bonds which unwound some of Monday's gains after Russia called back troops engaged in exercises near Ukraine.
Moscow had denied that the exercises, which began last week, had anything to do with events in Ukraine where a pro-Russian president was ousted. But President Vladimir Putin said on Tuesday that Russia has the right to use troops to protect Russians living in the region.
Italian and Spanish bonds have been remarkably resilient in the face of the geopolitical strains, avoiding the recent global risk aversion in a further sign worries over the euro zone debt crisis have eased.
Bets that the European Central Bank might loosen monetary policy, possibly as early as Thursday, also prompted investors to put some money in lower-rated assets to maximise their returns.
"They (Italian and Spanish bonds) are still in this sweet spot where yields are still, in relative terms, attractively high," said David Schnautz, a strategist at Commerzbank.
"This is the big picture trend that seems to still have some room to go in this low yield environment which should at the very least be reinforced by (ECB President Mario) Draghi and the ECB on Thursday."
Spanish 10-year yields shed 7 basis points to 3.45 percent, their lowest since October 2005, while Italian equivalents were 4 bps down at 3.42 percent, back at eight-year lows hit last week.
Signs of economic recovery in the currency bloc, improved outlooks on their creditworthiness and the ECB's pledge to do whatever it could to save the euro has largely insulated Spanish and Italian bonds from ructions in emerging markets.
"Turn the clock back a few years and these markets would be hit by contagion," said Nick Stamenkovic, a bond strategist at RIA Capital Markets in Edinburgh. "But you see more signs of growth in these countries ...(and) the ECB has backstops in place."
He was referring to the ECB's promise to buy government bonds, albeit under strict conditions, if a euro zone country gets in trouble.
In the core market, Bund futures fell 38 ticks to settle at 144.76, having hit their highest since May 2013 at 145.42 on Monday as investors piled into top-rated assets. Ten-year German yields, the benchmark for euro zone borrowing costs, rose 4 basis points to 1.59 percent.
Equivalent Austrian, Dutch, Finnish, French and Belgian yields also rose by 2-4 bps. Caution before the ECB's meeting on Thursday and uncertainty over how the Ukraine-Russia dispute will develop tempered the rise in yields.