* Italy sells long-term bonds, demand levels closely watched
* Some analysts recommend buying on dips before Italy polls
* Germany to sell two-year bonds with 0.25 pct coupon
By Marius Zaharia
LONDON, Feb 13 Italian bond yields fell slightly on Wednesday before an auction that will test investors' appetite for the country's longer-term bonds before an election later this month.
Italian debt has been under selling pressure recently as a comeback in polls by former Prime Minister Silvio Berlusconi's party raised the prospect of a fragmented parliament that could hamper the next government's reform efforts.
Final polls show Berlusconi's centre-left opponents are still on course to win the Feb 24-25 election, although they are likely to have to form a coalition with outgoing premier Mario Monti.
Ten-year Italian yields were 3.5 basis points lower on the day at 4.47 percent. Shorter-term yields also fell.
As well as in previous session, traders said paper was being snapped up by some domestic investors and foreign hedge funds betting that Italy will continue to keep a cautious fiscal policy after the election.
"We haven't seen much flows, but there have been some domestic (investors) and some fast money buying recently purely because yields have gone up," one trader said. "Some people are going to buy on dips, but it doesn't mean that we won't see more volatility between now and (the end of the month).
The government is aiming to sell up to 3.5 billion euros of three-year bonds and between 1 and 1.75 billion euros of 15- and 30-year bonds, together with five-year floating rate CCTeu certificates. The 30-year paper is the first on offer at a regular auction since May 2011.
"In terms of auctions, investors are a bit spoiled after the ... (good) results in January. If Italy sold only the lower end of its target range, that would be a disappointment," DZ Bank strategist Christian Lenk said.
He said he still saw Italian bonds as among the euro zone outperformers in the medium term as he did not expect the country to "completely reverse" recent economic reforms.
"We accept the fact that we will see volatility ahead of the elections. But we think they offer a decent yield pick-up especially as many other houses have turned more cautious," he said.
With a similar view, ING strategists also recommend a pre-election pick-up in Italian yields as a buying opportunity.
Spanish 10-year yields fell 7 basis points to 5.27 percent, with traders also citing domestic bargain hunters. Spanish debt outperformed its Italian counterparts as it does not face supply pressure this week.
Bund futures were 14 ticks lower at 142.40, having traded in a narrow 142.36-142.69 range during the session. Ten-year yields rose 2 bps to 1.66 percent.
Germany plans to sell 5 billion euros of new two-year bonds, carrying a 0.25 percent coupon. The previous two Schatz benchmarks had a zero percent coupon.
Two-year yields ended 2012 in negative territory due to fears at the time that potential large-scale automatic spending cuts in the United States could have sent the global economy into a deep recession. Those cuts have been avoided, or at least delayed, whetting investors' appetite for riskier assets.
Slightly-better-than-expected economic data and growing confidence in the euro zone's banking system as lenders repay crisis loans to the European Central Bank have also led to rising money market rates and higher short-term German yields.
"We expect a further rise in yields at the short end of the German curve, but the bonds are much cheaper than two months ago so the auction should be rather O.K.," DZ Bank's Lenk said.