* 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 Emelia Sithole-Matarise and William James
LONDON, Feb 28 Italian bond prices rebounded 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.
Nevertheless, they underperformed southern European peers
Spain and Portugal as the political crisis in the euro zone's
third-biggest economy deepened after party leaders ruled out the
most likely options to form a government. That raises the
chances another vote will need to be held.
The ECB's longstanding promise to buy bonds issued by
struggling states if needed has helped to limit the selloff in
higher-yielding debt, although some in the market question how
the scheme could be activated for Italy if it does not have the
credible pro-reform government required.
Italian 10-year bond yields were 8 basis
points lower on the day at 4.74 percent while low-risk German
Bund futures dipped 10 ticks to settle at 144.99.
"We have a bit of a rally now in Italy because spreads went
out quite a lot to begin with. I think the guys that have bought
into that rally will begin to take profit and I see Italian
spreads widening back out again," said Padhraic Garvey, head of
investment grade strategy at ING.
"But if you are willing to forget the noise and just go with
the bigger picture, yes, buy now (and) close your eyes, betting
it will be OK by year end."
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 seen in July last
year, before the ECB first hinted it might buy bonds.
For some investors, a potential coalition between Italy's
centre-left Democratic Party and the anti-establishment 5-Star
Movement - though rejected by the latter's leader Beppe Grillo -
was still likely. If such a government were to prove unstable,
however, it could trigger sharp swings in Italian asset prices.
Italian bond yields could rise 50-100 basis points in that
scenario, said Mirko Cardinale, head of strategic asset
allocation at Aviva Investors.
"There is also a real possibility of a 'Sunbathing
(care-taker) government' and fresh elections, which could lead
to heightened volatility in bond and equity markets, with bond
yields moving up 100-200 basis points," he added in a note.
Spanish bonds outperformed Italy for a ninth day running,
with analysts pointing to signs Spain was having some success in
reining in its spending and borrowing.
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 17 bps at
5.10 percent, while the premium investors demand to hold Spain
over Italy touched 36 bps - its narrowest since May last year.
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 slightly up on the
day at 1.46 percent but close to two-month lows hit on Wednesday
at 1.42 percent.