UPDATE 3-Italy's bond yields fall as govt wins confidence votes on electoral law


* Italian yields at lowest in almost 3 weeks

Italian govt wins no confidence votes on electoral law

* Portuguese yield hit lowest since Dec 2015

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Adds market reaction, latest confidence vote)

By Dhara Ranasinghe

LONDON, Oct 12 (Reuters) - Italy's borrowing costs fell to their lowest level in almost three weeks on Thursday after the government won the last of three confidence votes on a contested electoral law that is likely to penalise the anti-establishment 5-Star Movement.

The votes pushed the premium investors demand for holding Italian debt over top-rated German peers to its lowest since late September.

They also boosted sentiment towards peripheral bonds in a week that has seen tensions ease between Spain's government and the wealthy region of Catalonia pushing for independence.

For now, bond investor focus turned from Spain to Italy, where a third confidence vote on the disputed electoral bill was passed after two on Wednesday.

The proposed voting system is backed by three of the country's four largest parties, with the centre-left government looking to rush it onto the statute books ahead of an election that is due by May 2018.

Unlike the current rules, the new system would allow the formation of multi-party coalitions before the ballot, a factor likely to hurt 5-Star, which is topping most opinion polls and refuses to join alliances.

The bill now faces a secret ballot by the same parliamentarians in the lower house, giving dissident parliamentarians of all colours a chance to shoot it down, as happened in June to a previous electoral proposal.

Election uncertainty in Italy, the euro zone's third biggest economy, has been cited by analysts as one of the main risks facing regional bond markets.


"This law does help to a degree in that it reduces the probability of an anti-establishment government, so that could be a slight positive for Italy," said ING senior rates strategist Benjamin Schroeder. "It does also cast a light on election risks coming up."

Italy's 10-year bond yield fell as much as 4 basis points to around 2.124 percent, its lowest level since September 25.

The gap between Italian and German bond yields -- often viewed as a gauge of how investors view relative risks -- narrowed to around 168 basis points, its tightest in almost three weeks.

The strong performance of Italian bonds against euro zone peers came as markets absorbed fresh Italian bond supply. Italy sold more than 7 billion euros of government debt.

Most euro zone bond yields were a touch lower following the release on Wednesday of marginally dovish minutes from the U.S. Federal Reserve's last meeting.

Southern European bond markets continued to outpace the rest of the region, with Portugal's 10-year bond yield at its lowest level since December 2015.

Spanish yields were down 2 bps at 1.62 percent , having extended falls seen after Catalonia's leader earlier this week stopped short of making a formal declaration of independence.

Spanish Prime Minister Mariano Rajoy on Wednesday gave the Catalan government eight days to drop an independence bid.

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(Reporting by Dhara Ranasinghe; Editing by Gareth Jones and Toby Davis)