LONDON May 20 Yields on the euro zone's lower-rated bonds inched lower on Tuesday, but stayed well above their record lows as investors grew nervous about the outcome of this week's European elections.
The main concern was that if anti-austerity, euro-sceptic parties do well, ruling coalitions might change course to regain popular support, reigniting fears about debts and budget deficits.
Greece, where the ruling parties have the smallest majority, is seen as the biggest risk. Many investors fear that votes for Syriza, an anti-bailout leftist party, could weaken the ruling coalition further and pave the way for national elections.
Spanish 10-year yields fell 1 basis point to 3.01 percent, while Italian yields fell 2 bps to 3.13 percent. Both remained roughly a quarter of a percentage point above record lows hit last week.
Portuguese and Greek yields also dipped slightly, with traders pointing to a broader appetite for riskier assets as showcased by small gains in European shares and a solid performance on Wall Street overnight.
"Equities are getting a bit of traction and riskier assets are faring a bit better... But political fears have clearly come to the surface," said Nick Stamenkovic, a bond strategist at RIA Capital Markets.
In Italy, the EU elections are seen as a test of Prime Minister Matteo Renzi's political legitimacy. He came to power in February after a party coup which kicked out former premier Enrico Letta.
A good result would allow him to claim a mandate from voters for the ambitious reforms he has promised but has not delivered. A bad result would weaken him by exposing him to attacks from rivals inside and outside his party.
In contrast, Spain's Prime Minister Mariano Rajoy enjoys a strong majority and the domestic economic recovery has started to pick up.
This opens up an opportunity for investors to position for the elections via relative trades between Spain and Italy.
"If you think this is a lot of noise about nothing, then you should prefer Italy over Spain," said Luca Cazzulani, rate strategist at UniCredit in Milan.
"If you think there might be a risk in the elections, then you should prefer Spain over Italy," he said, adding that he did not expect anti-austerity parties to make "a strong enough showing to create long-lasting problems for the periphery."
Cazzulani expects easing measures by the European Central Bank to bring back the positive sentiment and said the looming EU elections had only persuaded investors to book profits on this year's rally and did not constitute "a change in fortunes". (Editing by Nigel Stephenson)