UPDATE 2-Bond risk premium in well-funded Italy hits two-year low
* Italy has completed 80 percent of its funding target
* Reduced supply to offer further support to Italian bonds
* Political tensions have eased - for now
LONDON, Aug 9 (Reuters) - The risk premium on Italian bonds hit its lowest since July 2011 on Friday, with the government's solid funding position and signs the euro zone's third largest economy is stabilising luring in investors.
The yield premium offered by Italian 10-year bonds over benchmark German Bunds fell below 250 basis points for the first time since July 2011 - less than half what it was in the two most intense flare-ups of the euro zone crisis in late 2011 and mid-2012.
The premium over Bunds is the main measure of the extra return investors demand to accept the risk of lending to the Italian government.
Barring any unexpected shocks, the Italian/German spread should continue to narrow for the rest of the European summer, in part because of a lack of supply of new bonds on offer for the rest of the year.
Italy has completed about 80 percent of its 2013 borrowing plan, according to Reuters data, allowing it to cancel a planned mid-August bond auction. Barclays estimates debt repayments for the rest of year will surpass debt sales by 18 billion euros.
Given their still relatively high yields - 4.2 percent over 10 years against just 1.7 percent for Germany - the reduced supply is likely to be met by sustained demand.
This strong financial position allowed Italy to fend off pressure from heightened political tensions last week, when investors worried that former premier Silvio Berlusconi's conviction for tax fraud could lead to a government collapse.
"We've had very good funding progress for most of the first half," DZ Bank rate strategist Christian Lenk said.
"The supply/demand dynamics are favourable and if you want some yield you cannot not invest in Italian bonds - they are still one of the largest markets."
About two thirds of the Italian debt is owned by domestic investors, who tend to hold domestic bonds for longer than foreign investors.
Nevertheless, while an immediate political crisis was averted last week when Berlusconi said the coalition government of Enrico Letta should continue despite the verdict against him, investors still have concerns about Italian politics.
Lawmakers are still arguing over whether Berlusconi should be ejected from parliament - a decision unlikely to come until next month but which has the potential to threaten the stability of the government.
"I see risks going forward because the political situation doesn't look great" said Jan von Gerich, chief strategist for developed markets at Nordea in Helsinki.
"We've averted a political crisis for now, but at the very least the government seems to have problems in implementing reforms. So I expect sentiment to change, maybe not in the next couple of weeks but before the end of the year."
Better than expected Chinese data overnight was the latest push for Italian bonds. But data this week showing Italy's economy shrank less than expected in the second quarter was also supportive, while the improvement in industrial activity in most of the euro zone has sent German Bund yields higher.
U-TURN MOOD CHANGE
The shift in investor sentiment towards Italy has been gradual. In November 2011, Italy was at the forefront of the crisis as Berlusconi's reluctance to reform an economy carrying a 2 trillion euro debt burden in his last days in office pushed the country's borrowing costs to unsustainable levels.
Yields fell under technocrat premier Mario Monti, whose fiscal reforms have been left in place by Letta's coalition.
The other key driver of yields has been European Central Bank action In late 2011 and early 2012, the ECB offered banks over 1 trillion euros in crisis loans - money some of them reinvested in higher-yielding peripheral bonds.
Mid-way through 2012, when investors were worried Spain's banking crisis would spread contagion to Italy, an ECB pledge to buy bonds eased worries of a euro zone break-up.
These backstops allowed Italy to frontload its debt sales in both 2012 and 2013.
But some investors remain cautious.
"I wouldn't get too excited about (Italy's funding progress) because they have to issue again next year," said Sandra Holdsworth, investment manager at Kames Capital, a group managing $84 billion.
For Italy to repeat this year's performance in debt markets, "you've got to see a recovery in the Italian economy and it's got to be a credible recovery," said Holdsworth, who has a "slight overweight" position in Italian and Spanish bonds.