* Spanish yields may rise before ECB bond buying activated
* Stalemate over bailout request stalls Spanish bond rally
* Yield rise may be slowed by investors' fear of missing out
By William James and Ana Nicolaci da Costa
LONDON, Sept 14 (Reuters) - Investors buying into a rally in Spanish bonds may need a strong stomach over the coming weeks as Madrid's reluctance to seek a bailout could force debt prices lower in the short term.
Bond yields have tumbled in recent weeks as some foreign investors, largely absent from Spanish markets in recent months, have started buying in anticipation of the European Central Bank purchasing bonds under a newly agreed support mechanism.
But ECB intervention is dependent on Spain asking for help via the region's bailout fund -- a step it is reluctant to take, particularly with bond yields currently at affordable levels.
Herein lies the bond investors' dilemma.
The longer Madrid delays seeking a rescue, the greater the chance investors will ditch their Spanish debt, pushing borrowing costs back towards unsustainable highs.
Yet such a rise could be the trigger for Madrid to seek a bailout, bringing in the ECB as bond buyer of last resort.
For investors, selling up before the ECB steps in could mean they miss out on hefty gains.
For Spain, taking a bailout and activating ECB support would be a bitter political pill to swallow, submitting the country's fiscal policy to external influence and possibly more austerity in an economy already in recession and with high unemployment.
It is far from clear who will blink first.
"It's like a nuclear standoff... both sides have their nuclear weapons, but actually they never want to use them," said Michael Leister, strategist at Commerzbank in London.
Two-year Spanish bond yields have fallen from more than 7 percent to 2.75 percent since late July when ECB president Mario Draghi first hinted at a bond buying plan.
On the basis of potential ECB support, Nick Gartside, International Chief Investment Officer at JPMorgan Asset Management which has $1.3 trillion of assets under management globally, said his funds took up a modest overweight position in Spain with a bias towards shorter-dated issues.
"We've been given the next chapter of the rulebook and it contains a pretty powerful set of policy options," he said
But awaiting signals from Madrid over its bailout request, Spanish bonds have struggled to maintain their downward momentum in recent days and two-year yields were last at 3.00 percent.
Spain's Prime Minister Mariano Rajoy said on Wednesday that he did not know if the country would need aid.
Euro zone finance ministers meeting in Cyprus on Friday pressed Spain to clarify whether it would seek financial help.
Some analysts say Rajoy, fearing a political backlash, may wait to seek aid until after regional elections in late October.
But, so long as the fundamental weakness in Spain's withering economy persists, bondholders will be tempted to bail out of their holdings and test Rajoy's resolve.
"All in all they will have to ask for the aid and the ECB support and unfortunately the decision will probably be made by the markets, primarily by putting Spanish bonds under pressure," said Cyril Regnat, fixed income strategist at Natixis in Paris.
For investors who bought the rally, that means the value of their Spanish bonds could get much worse before it gets better.
"It depends on how much volatility you are able to take. Ultimately you'd expect that what's in place at the moment means you're repaid on the shorter ones but it could be a bumpy ride in between," said Elisabeth Afseth, strategist at Investec in London
The rally in 10-year Spanish bonds, which sit beyond the scope of ECB's one- to three-year purchases, has pushed yields down more than 2 percentage points to 5.7 percent and movement from here will be closely watched to gauge market patience.
Portugal, Ireland and Greece all tried to fend off calls for them to seek a bailout, but succumbed to market pressure once markets drove the yield on a 10-year bond above 7 percent.
"(Yields) would have to rise significantly or they would have to rise at a speed that makes it quite worrisome, for Spain to make up their mind. Also, the curve needs to flatten quite dramatically to make funding at the front end of the curve... become less viable," said Gianluca Ziglio, strategist at UBS.
Yields on Spanish bonds with two to 10-year maturities would have to rise to 6.5 percent and the 10-year yield spread over Germany reach 520 bps, before Spain got into a situation where it would start considering asking for formal help, he said.
However, even if some investors begin to sell Spanish debt again, the move to those crisis levels may not be a sharp one because of a reluctance to get caught short when the aid request does come and sparks a fresh rally.
"As long as we still believed that the political will was still there... at (6 to 6.5 percent), it's probably an opportunity where one could look to go a little bit longer," said Michael Lee, senior portfolio manager at Wells Fargo Advantage International Bond Fund.
The fund, which has about $1.6 billion under management, currently holds a neutral position in Spanish debt relative to its investment benchmark because the risk of short-term price swings was difficult to manage, Lee said.