April 25, 2014 / 3:56 PM / 3 years ago

Fitch boosts Italian bonds as Ukraine crisis prompts search for quality

* Italian yields hover above record lows

* Lower-rated bonds, stocks struggle

* Fitch upgrades Spain, lifts Italy outlook (Updates with Spanish rating upgrade)

By John Geddie

LONDON, April 25 (Reuters) - Italian bond yields held just above record lows on Friday after Fitch upgraded Italy's ratings outlook, as concern about Ukraine prompted investors to pull out of lower-rated paper.

Spanish debt also held its own throughout the day. Fitch lifted Spain's rating by one notch to BBB+, with a stable outlook after the market close.

At the height of the euro zone crisis, bonds issued by Italy and Spain were considered among the riskiest investments available. Now they are an increasingly popular bet as the two economies have started to recover and the returns on core euro zone debt remain near historic lows.

Italian 10-year yields dipped 1 basis point to 3.11 percent, just above the record low of 3.07 percent hit last week. Spanish yields fell 1 bps to 3.06 percent

"It is a reminder that the world has changed its mind about periphery," said Luca Jellinek, European head of fixed income at Credit Agricole.

In contrast, lower-rated bonds, such as Portugal's and Greece's, global stocks and currencies struggled after Ukrainian forces killed up to five pro-Russia separatists and Russia conducted military drills near the border, raising fears it was gearing up to invade.

VAST IMPROVEMENT

Emerging from recession at the end of last year, Italy has benefited from a vast improvement in financing conditions. Fitch pointed out that its average issuing yield in the first quarter or the year was 1.6 percent, a historic low.

Fitch, which already rates Italy one notch above the other two main agencies Standard and Poor's and Moody's, affirmed the country at BBB+, raising its outlook to stable from negative

Italy sold 5 billion euros of debt on Thursday, hitting nearly 40 percent of its annual funding target.

"Italian bonds are not traded as a credit any more, but more on the (central bank) rates outlook like German Bunds," said one government bond trader.

Bund yields fell 5 bps to hit 1.48 percent, while yields on Greek bonds - the highest in the bloc - rose 10 bps to 6.26 percent.

With official interest rates already at historic lows, the European Central Bank has raised the prospect of loosening its policy further, encouraging investors to buy peripheral debt.

Some think yields are too low.

"We have been, and remain, overweight in the euro periphery, though our sense is that we have now witnessed the majority of the rally," said Mark Dowding, a senior portfolio manager at BlueBay, one of Europe's largest bond funds.

But others see little resistance to more declines, especially with the ECB raising the possibility of a programme of asset purchases known as quantitative easing.

"In an environment where, rightly or wrongly, you have ongoing speculation of further ECB action down the line, investors are reaching out for the highest levels of yield you can get in the euro zone," ICAP strategist Philip Tyson said.

Spain, like Italy, has enjoyed much improved market access in 2014. It has completed more than 40 percent of its funding programme already, paying record low costs to borrow 5.6 billion euros at auction on Thursday.

In further evidence of ratings agencies taking a more positive view on the periphery on Friday, both Fitch and Standard and Poor's upgraded Cyprus, less than a year after the country was bailed out.

S&P raised Cyprus' rating to B from B-, with a positive outlook. Fitch affirmed Cyprus' B- rating, raising its outlook to stable from negative. (Additional reporting by Marius Zaharia Editing by Larry King Editing by Jeremy Gaunt)

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