* Spain to sell 7 bln euros of 10-year bonds
* Auction seen as test of appetite for peripheral debt
* Demand exceeds 20 bln euros by mid-morning
* South Europe yields rise as investors make space
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates throughout)
By Abhinav Ramnarayan
LONDON, June 26 (Reuters) - Southern European bond yields rose on Tuesday as Spain prepared to sell 7 billion euros of 10-year debt in a test case of the market’s ability to withstand political uncertainty in the European Union.
The syndicated deal by Spain - a structure where borrowers appoint banks to sell their bonds directly to investors — looked set to be completed on Tuesday with demand exceeding 20 billion euros by mid-morning.
Two weeks ago, bankers who manage government bond sales said the deal was unlikely to materialise after the emergence of an anti-establishment government in Italy.
In addition, Spain has also seen a change in government with Pedro Sanchez and his Socialist party taking office on June 1 after chairing a motion of no confidence against Prime Minister Mariano Rajoy, who lead the country as the head of the conservative People’s Party since 2011.
But on Tuesday, market sentiment appeared to be positive. Euro zone bond yields rose, suggesting investors were clearing space in their portfolios for the new Spanish bond.
“From a size perspective, the bond deal was in the middle of the anticipated range,” said Rabobank rates strategist Lyn Graham-Taylor.
Another strategist, who works for one of Spain’s primary dealers, said the bond sale provided a good opportunity for some investors to switch from Italian to Spanish bonds.
“Yet, it is not the kind of demand we have seen in recent Spain deals, and this is mostly because of the volatility in the market recently because of Italy. The caution is still there, contagion is not completely gone though it is definitely much better than before,” he said, declining to be named.
France was also in the market, reopening its Green bonds maturing in 2036, and was set to raise 4 billion euros from the sale.
Selling in euro zone government bond markets was concentrated in Italy, with 10-year yields up 7 basis points on the day at 2.92 percent. Spanish and Portuguese equivalents were up 4 bps each.
During the euro zone debt crisis of 2011-2012, all lower-rated debt from governments on the euro zone periphery sold off on contagion fears when Greece appeared on the brink of default.
But that effect seems to diminished. Spanish and Portuguese debt sold off alongside Italy as a coalition of the 5-Star Movement and League took office just a few weeks ago in Rome, but soon recovered.
The spread between Spanish and Italian 10-year bond yields widened to 147 bps on Tuesday compared with 47 bps at the start of May. Earlier this month, it reached 165 bps, its widest since January 2012 .
“We find Spanish government bonds are sufficiently insulated from market volatility as Spain does not face the same structural and political challenges as Italy,” Mizuho analysts said in a note.
Investors were also watching Germany, where Chancellor Angela Merkel is seeking a Europe-wide agreement on migration. She faces a revolt on the issue from her Bavarian coalition allies that threatens her government.
This possibility kept safe-haven German Bund yields pinned near Monday’s one-month lows of 0.304 percent.
Greek government bond yields fell after ratings agency S&P Global raised its long-term debt rating on Greece on a reduction in debt risks from the creation of cash buffers and extension of maturity on its debts.
Reporting by Abhinav Ramnarayan; Additional reporting by Paul Day and Dhara Ranasinghe Editing by Matthew Mpoke Bigg