(Recasts with further fall in Bund yields, fresh analyst comments)
By Emelia Sithole-Matarise
LONDON Aug 15 German Bund yields hit a new record low on Friday as reports of attacks in Ukraine on a Russian convoy added impetus to a market buoyed by bets for more European Central Bank policy easing.
A Ukraine military spokesman said Ukrainian forces had engaged and destroyed part of an armed convoy that Russia says is humanitarian aid for pro-Moscow separatists in eastern Ukraine.
The confirmation by Kiev that its forces clashed with Russian troops inside Ukraine spurred flows into assets perceived to be safe such as top-rated German, U.S. and British bonds. Riskier assets such as equities cut gains.
Bund yields dropped 5.6 basis points to a record low of 0.958 percent, notching their biggest weekly percentage fall since the week ending Sept. 27, 2013.
They initially breached that 1 percent level for the first time on Thursday after data showed the euro zone economy failed to grow in the second quarter, even before sanctions the West and Russia imposed on each other over the conflict in Ukraine started to bite.
Many in the market expect yields to hug these lows or go even lower in coming days if the fighting in Ukraine escalates over the weekend and as the outlook on the euro zone economy increases expectations of more aggressive policy easing from the European Central Bank.
"There's the huge risk that there could be a major military involvement of Russia in Ukraine and this would be an even worse situation compared to the one we had when there was this (Russian) involvement in Crimea," said Daniel Lenz, a bond strategist at DZ Bank.
"The Bund is very much the heat curve (map) for what's happening in this geopolitical situation. Now I would not bet on any limit to the downside (in Bund yields) if there really was an attack on this Russian convoy."
Yields on lower-rated Italian and Spanish bonds also hit all-time lows at 2.579 percent and 2.272 percent respectively, on the market belief that the ECB will eventually have to embark on asset purchases, a monetary policy tool known as quantitative easing.
The ECB is unlikely to take fresh measures in the next few months as it wants to assess the impact of cheap four-year loans to the banking sector it will start to dole out in September and December.
But pressure on it to act sooner rather than later could accelerate next week if preliminary euro zone manufacturing activity data shows counter sanctions between the West and Russia are beginning to take a toll.
"If QE expectations do accelerate, expect sharper moves downward in Bund yields, but if QE continues to be delayed, this will also benefit nominal bonds as the market will price mounting deflation risk and a central bank far behind the curve. Neither hurts core bonds," RBS strategists said in a note.
They said they would not be sellers of Bunds even if yields were to fall below the 0.96 percent level. That is the level at which Bunds would become "statistically expensive", according to the RBS strategists' own fair-value models which take into account inflation, private sector loan growth and manufacturing activity surveys.
"Even if Bunds get to 95 basis points, we would not be sellers with data momentum still slowing; rather, our concern would be that longs (buyers) would move further down the curve from 10-year (Bunds)," they said.
The ultra-low level in German yields is stoking fears that the euro zone is facing a "lost decade" of economic stagnation and incessant struggle to lift inflation, similar to that of Japan.
Some in the market are, however, cautious.
"We still don't believe the euro area is going into Japan-style deflation," said Martin Harvey, portfolio manager (fixed income) at Threadneedle Investments.
"Therefore on the medium-term basis we think the (Bund) valuations here are poor but you have to respect that the changes that we've seen over the last couple of weeks are going to influence those yields lower still. We maintain a defensive position in terms of bond markets," he said. (Editing by Susan Fenton)