* Periphery's yields dip amid Ukraine tensions
* Investors see Spain, Italy as new sweet spot
* Returns appeal as shock risks diminish (Updates prices, adds fresh comments)
By John Geddie and Marius Zaharia
LONDON, April 16 (Reuters) - Italian and Spanish bond yields fell to multi-year lows on Wednesday, offering relatively safe, high returns that attracted investors with one eye on the developing crisis in Ukraine.
Investor confidence in the euro zone's rehabilitation and the potential for ECB asset purchases have cushioned the debt of the peripheral countries against geopolitical shocks.
"The stance of the ECB is for sure expansionary ... we are in a sweet spot," said Jacopo Turolla, portfolio manager at Gestielle Asset Management in Milan.
Spanish 10-year yields fell 3 basis points to 3.06 percent, an 8 1/2-year low, while Italian 10-year yields fell 2 bps to 3.11 percent, a record low. Yields on safe-haven Bunds rose 1 bps to 1.49 percent as Germany sold 3.4 billion euros ($4.7 billion) of 10-year debt.
Foreign investors who shunned peripheral countries during the worst of the euro zone sovereign-debt crisis are now much more optimistic about their prospects.
"At least in the case of Spain, the market is responding to the correction of the (economic) imbalances, the reform effort," Pablo de Ramon-Laca, head of funding at the Spanish treasury, told Reuters on Tuesday.
The Italian government's reform agenda came in for criticism this week, prompting the European Commission to remind Italy it was committed to balancing its budget. But data from the Bank of Italy showed foreign investors were returning en masse. And a sale of inflation-linked bonds to domestic retail investors closed ahead of schedule on Wednesday after orders reached 10 billion euros.
With the European Central Bank standing ready to nurture growth in the euro zone with radical measures such as quantitative easing, investors are confident peripheral debt is now almost immune to outside shocks.
No sign of selling pressure was evident as tension grew in Ukraine, where separatists flew the Russian flag over armoured vehicles taken from Kiev's army on Wednesday.
"The issue of Russia doesn't necessarily affect one's opinion on Spain repaying their debt, which was the case a few years ago," said Bill Street, head of EMEA investments at State Street Global Advisers. He added any rise in yields due to geopolitical concerns would be a buying opportunity.
The total returns are also appealing. So far this year, Italian bonds have returned 6.3 percent and Spanish bonds 6.7 percent, around double the 3.2 percent returns on German paper, according to Citi's World Government Bond Index.
Many predict that the spread they offer over German yields will continue to fall. Banks such as RBS and Credit Agricole expect a difference of just 100 bps by the end of the year from around 160 bps at present.
"It has been an extraordinary rally," said Sandra Holdsworth, an investment manager at Kames Capital. "It's very similar to the convergence that occurred before the euro came into existence back in the late nineties."
Sovereign debt managers are able to take advantage of this cheap, and readily available, market funding to actively manage their debt profiles. Spain said on Tuesday it may use bond swaps and buy-backs to soothe investor worries about their abilities to meet hefty repayments in years ahead.
More than half of Spain's 914 billion euro debt matures within the next four years, according to Thomson Reuters data. ($1 = 0.7243 Euros) (Reporting by Marius Zaharia; Editing by Larry King)