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South European bond premiums near lows as investors book in yields

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr

LONDON, Aug 2 (Reuters) - The premium investors demand to hold South European government debt over the German equivalent were on Wednesday close to their lowest levels in weeks as investors took more risks to try and lock in higher returns.

Euro zone government bonds in general and low-rated Southern European debt in particular are in demand this week after a rise in Spanish and Italian yields has enhanced their appeal.

Lower bond supply and expectations that extraordinary stimulus will only be withdrawn gradually were also fuelling demand, anlaysts said.

"It is now too expensive to be short euro zone government bonds from an investor point of view. You would be foregoing all the carry," said ING strategist Benjamin Schroeder, referring to a strategy where investors borrow at a low interest rate and buy higher yielding bonds.

"You would be better off waiting for two months when the taper strategy becomes clear before reconsidering your position," he said.

Most euro zone government bond yields have risen sharply since European Central Bank chief Mario Draghi signalled in late June that the bank was open to policy tweaks.

Expectations now are for the ECB to announce in the autumn that it will taper its 2 trillion euro bond buying scheme and then begin actual withdrawal in 2018.

Germany's 10-year borrowing costs doubled in the weeks after June 27, when Draghi made his speech.

Low-rated Italian, Spanish and Portuguese government bond yields also rose sharply over that period. But the high yields they were now offering against a relatively benign political backdrop meant they became an attractive proposition for investors.

The yield spread between these South European government bonds and the German equivalent is at some of the tightest levels in weeks.

The Italian government bond yield spread over Germany, for example, was close to its tightest level all year on Thursday at 152 basis points, having hit that level late on Tuesday afternoon.

Most euro zone government bond yields were flat to a touch higher on Wednesday.

That spread was as wide as 212 bps in April this year, at the height of concerns over elections in France and possible snap elections and Italy and implications of those events for the future of the single currency bloc.

However, as political risks died down, those moves began to reverse. Even though an end to extraordinary stimulus is likely to hit South European borrowing costs the hardest, most expect the ECB to withdraw it only gradually.

"I suspect we will still have 30-40 billion euros of purchases (per month) for the first six months of 2018," said ING's Schroeder.

The ECB currently buys 60 billion euros of debt securities every month as part of measures to boost the euro zone economy.

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(Reporting by Abhinav Ramnarayan; editing by Richard Balmforth)