* Italian bond yields fall to lowest since early Oct
* Gap over Bund yields tightest since Sept
* U.S. Fed rate decision later in day
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds latest news on Greece and clarifies demand for French bonds)
By Dhara Ranasinghe
LONDON, Jan 29 (Reuters) - Italy’s 10-year bond yield fell to its lowest level since early October on Wednesday as sentiment in world markets improved and easing concern about Italian political risks kept investors interested in the euro zone’s higher-yielding debt markets.
Fears about the economic impact from the coronavirus outbreak in China have boosted demand for safe-haven European government bonds in the past week.
But peripheral government bonds, which often trade in line with other riskier assets, have outperformed even on days when stocks have sold off.
Analysts say a “flight-to-yield” is dominating over “flight-to-quality” - a phrase that describes the rush to top-rated, safe assets at times of uncertainty.
With more than half of the euro zone government bond market in negative yield territory, sell-offs or auctions tend to be viewed as an opportunity to buy bonds offering any yield.
Greece on Tuesday attracted record orders for a 15-year bond sale. It also sold 487.5 million euros ($540.83 million) of six-month treasury bills to refinance maturing debt, its debt agency PDMA said on Wednesday.
France also received strong demand for a 5 billion euro ($5.55 billion), 30-year bond sold via a syndicate of banks on Tuesday, with final demand reaching 26 billion euros ($28.84 billion).
French 30-year bond yields are at 0.68%, but 10-year yields are at -0.12%, which essentially means investors are paying the French government to hold those bonds.
A ratings upgrade for Greece on Friday and the failure of Italy’s right-wing League to win a key regional election at the weekend, bringing relief to an embattled government, have also boosted peripheral debt.
“The negative yields backdrop and the view that this will stay for a while means the traditional investor base is having second thoughts about staying in the German bond market,” said Rainer Guntermann, a rates strategist at Commerzbank.
“In the periphery, there are some country specific factors - the weekend election in Italy, the credit ratings upgrade in Greece.”
Italy’s 10-year bond yield fell 6 basis points to 0.964% , its lowest level since early October.
It has tumbled over 25 bps this week and is on track for its biggest weekly fall since late August. Even with demand for safe assets high amid the coronavirus jitters, German Bund yields are just 4 bps lower so far this week.
The closely-watched gap between Italian and German Bund yields narrowed to 132.70 bps — its tightest since mid-September.
“What we have seen is that fundamentals in southern Europe have improved significantly and in the negative-yielding environment, Italy and Greece are benefiting,” said Pooja Kumra, European rates strategist at TD Securities.
Data on Wednesday showed morale amongst Italian manufacturers and consumers rose in January. On Tuesday, Economy Minister Roberto Gualtieri said that the government’s 2.2% deficit target would be “very easily reachable.”
Focus turned to a U.S. Federal Reserve rate decision. The Fed is expected to keep rates on hold on Wednesday but discuss possible changes to how a key overnight borrowing rate is managed. ($1 = 0.9014 euros) ($1 = 0.9014 euros)
Reporting by Dhara Ranasinghe; Editing by Angus MacSwan and Nick Zieminski