* Italian, Portuguese yield gap over Bunds at 2-month highs
* Investors fear domestic instability after EU elections
* Italy vs Spain emerges as key pre-election trade (Updates prices, adds fresh comments)
By Marius Zaharia and Emelia Sithole-Matarise
LONDON, May 20 (Reuters) - Yields on the euro zone’s lower-rated bonds rose on Tuesday amid concern this week’s European Union elections might derail domestic economic reforms.
The premium that Italian 10-year yields and Portuguese 10-year yields offer over benchmark German Bunds rose to two- month highs of 189 and 264 basis points, respectively.
Investors are mainly concerned that Eurosceptic parties might do well. That could cause ruling coalitions to change course to regain popular support and reawaken fears about debts and budget deficits.
Greece, where the ruling parties have the smallest majority, is seen as the biggest risk. Many investors fear that votes for Syriza, an anti-bailout leftist party, could weaken the ruling coalition further and trigger fresh national elections.
“People are a bit more aware of the risk of European elections, which they surpringly weren’t paying much attention to last week,” said Alessandro Tentori, global head of rates strategy at Citi.
“It’s getting a bit more traction in that the more bonds suffer the more late-comers to the (peripheral bond) rally tend to feel the heat more so they are getting nervous.”
Italian yields rose 11 basis points to 3.26 percent, Portuguese yields jumped 10 bps to 4 percent and Irish yields rose 8 bps to 2.81 percent.
Traders said investors also felt overloaded with peripheral debt after buying 5 billion euros of Spanish inflation-linked bonds and 14.25 billion of Italian debt last week. Below-forecast euro zone first-quarter growth figures from last week also weighed on sentiment.
Spain plans to sell up to 3.5 billion euros of bonds on Thursday. Italy is offering up to 2.5 billion of five-year bonds in exchange for some 2015 and 2017 bonds.
Some in the market see the rise in peripheral yields as a buying opportunity, especially with the European Central Bank primed to ease monetary policy further.
“Generally we are still constructive on the periphery on a medium-term basis and we regard this as a correction where we think there are there opportunities to add to positions again,” said Michiel de Bruin, head of global rates at F&C Investments.
“The move in Italy particularly has been most pronounced and that’s a market we follow with particular interest ... We are using this correction to add a little bit to Italy again.”
In Italy, the EU elections are seen as a test of Prime Minister Matteo Renzi’s political legitimacy. He came to power in February after a party coup which kicked out former premier Enrico Letta.
A good result would allow him to claim a mandate from voters for the ambitious reforms he has promised but has not yet delivered. A bad result would expose him to attacks from rivals inside and outside his party.
In contrast, Spain’s Prime Minister Mariano Rajoy enjoys a strong majority and a faster economic recovery at home.
This opens up an opportunity for investors to position for the elections via relative trades between Spain and Italy.
“If you think this is a lot of noise about nothing, then you should prefer Italy over Spain,” said Luca Cazzulani, rate strategist at UniCredit in Milan.
“If you think there might be a risk in the elections, then you should prefer Spain over Italy,” he said, adding that he did not expect anti-austerity parties to make “a strong enough showing to create long-lasting problems for the periphery.”
Spain’s yields were 8 bps higher at 3.10 percent, but remained, like Italy‘s, roughly a quarter of a percentage point above record lows hit last week.
The premium offered by Italian bond yields over Spanish ones rose to 16 bps from 4 bps in the past week, an eight-month high. (Editing by Larry King)