* Italian debt rebounds as ECB backstop keeps market calm
* Spain outperforms Italy, spread at narrowest since June
* Heavy long bias towards periphery creates selloff risks
By William James
LONDON, Feb 28 Italian bonds pared recent losses
on Thursday as investors took stock of the country's political
stalemate, with concerns over possible fresh elections offset by
the European Central Bank's bond-buying backstop.
The political crisis following indecisive election results
in Italy deepened on Wednesday when two party leaders ruled out
the most likely options to form a government, raising the
chances of a fresh vote.
But the ECB's longstanding promise to buy bonds issued by
struggling states if needed has helped to limit the selloff in
Italian bonds. It was expected to continue doing so over the
Italian 10-year bond yields were 7 basis
points lower at 4.76 percent while German Bund futures
were steady on the day at 145.09.
"There will be a risk premium on Italian yields until a new
government is formed and we know what they're going to do with
structural and fiscal reforms," said Nick Stamenkovic,
strategist at RIA Capital Markets in Edinburgh.
"But we're not going to see a return to the levels we saw a
year ago because the ECB has pledged to use its balance sheet if
Italian 10-year yields have now trimmed around 15 basis
points of the 50 basis point rise seen earlier this week.
Current yields are well above lows near 4.12 percent hit in
January but still lower than the 6.6 percent in July last year
before the ECB's first hinted at its bond-buying support.
Spanish bonds also rallied, outperforming Italy for a ninth
day running, with analysts pointing to signs Spain was having
some success in reigning in its spending and bringing.
The Treasury minister said on Thursday the 2012 deficit was
6.74 percent - missing a European-agreed target of 6.3 percent
but within a range that markets will see as acceptable.
"If you combine the positive news from Spain on the fiscal
side with the uncertainty coming out from Italy you see a
shrinking of the spread," said Sergio Capaldi, fixed income
strategist at Intesa SanPaolo.
Spanish 10-year yields were down 10 at 5.16
percent, while the premium investors demand to hold Spain over
Italy touched 37 bps - its narrowest since June last year.
Nevertheless, bond markets' risk-hungry start to the year,
when investors loaded up on higher-yielding debt from across the
region's struggling peripheral states, has left many exposed to
further weakness in Italian BTP bonds.
The heavy bias this year towards betting on a rise in
Italian bonds means that any fall in prices leads to lower
profits or even outright losses for investors, giving a strong
incentive to sell out quickly if the situation worsens - a
potential snowball effect that could benefit German debt.
"We continue to maintain a positive view on Bunds, with the
view that yields go to 1.25 percent and possibly beyond," one
Ten-year German yields were last at 1.45
percent, flat on the day and holding close to two-month lows hit
on Wednesday at 1.42 percent.