* Investors seek safe havens amid escalation in Ukraine tensions
* German Bund yields see biggest daily fall since Sept
* Italy slips back into recession as Q2 GDP unexpectedly shrinks (Updates prices, adds fresh analyst comments)
By Marius Zaharia
LONDON, Aug 6 German Bund yields fell to record lows on Wednesday as investors sought refuge in top-rated assets after Russia appeared to step up military exercises near its border with Ukraine.
Data showing Italy unexpectedly slipped back into recession in the second quarter exacerbated worries about the euro zone's economic recovery, helping to fuel demand for safe-haven investments.
"Geopolitical strains in Ukraine with reports of possible Russian retaliation are fuelling a flight to quality, and adding to the risk sentiment was this disappointing data out of Italy," DZ Bank rate strategist Christian Lenk said. "These two factors justify yields moving back towards record lows."
Moscow has massed around 20,000 troops on Ukraine's eastern frontier, NATO said on Wednesday. The western alliance warned that Russia might use a humanitarian or peacekeeping mission as a pretext to send troops across the border.
President Vladimir Putin has ordered his government to prepare retaliatory measures following the latest round of Western sanctions, which may include banning European airlines from flying over Russian territory.
Bund yields fell 8 basis points, their biggest daily fall since September 2013, to a record low of 1.097 percent. Bund futures were up 89 ticks at 148.90.
Germany sold 2.5 billion euros of five-year bonds at much lower yields than at a previous sale, with a downbeat inflation and growth outlook contributing to the solid result.
The European Central Bank meets on Thursday but is not expected to alter policy. It has signalled it will assess the effects of June's rate cuts and new long-term loans to banks (TLTRO) it plans to make in September before taking further steps.
But it is likely to emphasise its readiness to act if the inflation outlook should deteriorate further.
"There is no potential for yields to rise significantly in the near term, given the prospect of dovish comments from the ECB, the TLTROs in September and given that the economy remains weak," said Patrick Jacq, rate strategist at BNP Paribas.
Data showed German factory orders fell 3.2 percent in June, versus expectations of a 1 percent rise.
Italy's economy unexpectedly shrank by 0.2 percent in the second quarter from the first three months of the year, taking it into its third recession since 2008.
Italy, along with Spain, teetered on the edge of disaster when the euro zone debt crisis reached its nadir in 2011 and 2012. Now it badly needs growth to help lighten one of the world's biggest debt burdens, currently at more than 2 trillion euros. Spain's economy, by contrast, grew 0.6 percent in the second quarter, its fastest pace since 2007.
The West's sanctions against Russia may also weigh on Europe. Finland's prime minister said on Wednesday the country might fall back into economic trouble because of the sanctions.
The poor economic data, coupled with a general preference for higher-rated assets worldwide, pushed peripheral debt yields higher.
Italian 10-year bond yields rose 6 basis points to 2.82 percent. Spanish yields rose 3 basis points to 2.59 percent.
Many expect Spanish bonds to keep outperforming their Italian peers.
"Spain has done better than Italy in fundamental terms. We expect this trend to continue with Spanish GDP outperforming Italy over the coming three years," Citi strategists said in a note.
"Trends in the global demand for EGBs (euro zone government bonds) still suggest a preference to allocations in Spanish government bonds, but also net buying of Italy has been strong in the first half of the year. We expect Bonos to continue outperforming BTPs, albeit at a slower pace compared to 2013." (Additional reporting by Emelia Sithole-Matarise; Editing by Catherine Evans, Larry king)