* 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 with latest moves, new comments)
By Marius Zaharia
LONDON, May 20 (Reuters) - Yields on the euro zone’s lower-rated bonds rose on Tuesday, as investors grew increasingly nervous about the outcome of this week’s EU elections, which could derail domestic economic reforms.
The premium that Italian 10-year yields and Portuguese 10-year yields offered over benchmark German Bunds rose to two- month highs of 189 and 264 basis points, respectively.
The main concern was that Eurosceptic parties might do well, causing ruling coalitions to change course to regain popular support, reigniting 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 pave the way for national elections.
“Political fears have clearly come to the surface,” said Nick Stamenkovic, a bond strategist at RIA Capital Markets.
Italian yields rose 5 basis points to 3.20 percent, Portuguese yields rose 4 bps to 3.94 percent and Irish yields rose 5 bps to 2.77 percent. Spain’s yields were flat at just over 3 percent, but remained, like Italy‘s, roughly a quarter of a percentage point above record lows hit last week.
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.
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.
Marius Daheim, chief strategist at Bayerische Landesbank, said the rise in peripheral yields was a buying opportunity.
“You can assume that given all the austerity people will punish their current governments in the EU elections. But it is a bit naive to think that this would automatically topple those governments,” he said.
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.”
The premium offered by Italian bond yields over Spanish ones rose to 18 bps from 4 bps in the past week, an eight-month high.
Cazzulani expects easing measures by the European Central Bank to bring back the positive sentiment and said the looming EU elections had only persuaded investors to book profits on this year’s rally and did not constitute “a change in fortunes”. (Editing by Larry King)