April 17, 2018 / 11:37 AM / 7 days ago

UPDATE 2-South European debt in demand as top Italian lender sheds bad loans

* Intesa deal seen as positive for Italian economy

* Italy-Germany spread at tightest in almost two weeks

* Weak ZEW survey also lifts peripheral debt

* Bund yields dip towards 0.5 pct

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices for close)

By Fanny Potkin and Abhinav Ramnarayan

LONDON, April 17 (Reuters) - Southern European government borrowing costs fell on Tuesday, outperforming better-rated peers, as Italian lender Intesa Sanpaolo reached a landmark deal that analysts said is positive for the euro zone’s third-largest economy.

Intesa, Italy’s largest bank by market capitalisation, reached a 3.6 billion euro ($4.45 billion) deal with Swedish group Intrum that will allow it to shed 10.8 billion euros of bad loans from its balance sheet.

Analysts say the deal brightens the outlook for Italian banks, which still hold some 285 billion euros in soured debt four years after a deep recession pushed the figure to 360 billion euros.

“This news is ... relevant to the capacity of the banks to provide loans to the real economy, and that feeds through to a more bright outlook for the Italian economy,” ING interest rate strategist Martin van Vliet said in Amsterdam.

The premium investors pay to hold Italian 10-year bonds over top-rated German peers tightened by 3 basis points (bps) to 124 bps, the smallest gap for almost two weeks.

Van Vliet put the spread tightening down to the combination of Intesa and Italian political developments, noting that the bank is also one of the biggest owners of Italian government bonds.

Italian media reported that President Sergio Mattarella is looking at whether to appoint Speaker of the Senate Elisabetta Alberti Casellati as a neutral institutional figure to mediate between Italian political parties trying to form the next government.

In late afternoon trade, Italian bond yields were down almost 5 bps at 1.75 percent, leading a broad fall in euro zone debt yields.

Portugal also outperformed, with its gap over 10-year Bunds at its tightest since late January at 108 bps.

Germany’s 10-year bond yield was down 2 bps at 0.51 percent.

Elsewhere, a survey by the ZEW research institute showed on Tuesday that German investor morale had hit its lowest level since November 2012, reflecting weak economic data and growing unease about possible damage to Europe’s largest economy from a trade dispute between the United States and China.

The survey of economic sentiment provides further evidence of a decline in euro zone optimism, which could serve to keep European Central Bank stimulus flowing.

After a stellar 2017, optimism over euro zone growth this year has faded, boosting expectations that the European Central Bank will continue asset purchases until the end of the year rather than stop in September, as some had speculated, said ING strategist Benjamin Schroeder.

$1 = 0.8081 euros Reporting by Abhinav Ramnarayan and Fanny Potkin Additional reporting by Dhara Ranasinghe Editing by Kevin Liffey and David Goodman

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