By Dhara Ranasinghe
LONDON (Reuters) – Concern that Britain might leave the European Union and a setback for Italy’s government in municipal elections brought political risks to the fore on Monday, hurting peripheral bonds and pinning German Bund yields near record lows.
Yields on Italian and Spanish 10-year bonds rose more than 5 basis points as risk aversion took its toll.
In contrast, safe-haven German bonds, already on a roll after Friday’s weak payrolls data dashed expectations for an imminent hike in U.S. rates, held firm with 10-year yields within sight of a 0.05 percent record low hit last year.
As the June 23 referendum on the UK’s EU membership draws closer, unease about a potential Brexit has grown.
The campaign for Britain to leave the EU has taken a 4-5 percentage point lead, according to online polls by ICM and YouGov on Monday that sent sterling towards three-week lows against the dollar.
Concerns about political risk in Europe were also fueled by gains for the anti-establishment 5-Star Movement in Italian municipal elections on Sunday.
The 5-Star Movement looked likely to take charge of Rome, Italy’s capital city, piling pressure on Prime Minister Matteo Renzi. The party, campaigning hard against corruption, also made gains in other Italian cities, echoing the rise of anti-establishment parties across Europe. 
“We have a poll showing the leave camp in the lead in the UK and in Italy we see the 5-Star Movement gaining ground, so political risk is a key issue,” said KBC strategist Piet Lammens.
Italian 10-year bond yields
Portugal’s 10-year bond yield
Sterling fell 1 percent against the dollar, before paring losses, and the costs of hedging against swings over the coming months hit their highest since late 2008 on Brexit jitters.
Analysts said growing volatility in sterling was starting to spill over into peripheral bond markets and could become more pronounced as the referendum approaches.
A potential Brexit is seen hurting the euro zone economy and fuelling independence drives such as in Spain’s wealthy Catalonia region. Italy’s 5-Star Movement has said it wants a referendum on euro membership.
Germany’s 10-year Bund yield edged up to 0.081 percent – having hit its lowest in more than a year on Friday at 0.065 percent and posted its biggest one-day fall in a month
That move followed Friday’s unexpectedly weak U.S. jobs data, putting a test of the zero level back on the cards for German Bund yields.
Later on Monday, Federal Reserve Chair Janet Yellen will address an event in Philadelphia. Markets will pay close attention to her last official remarks before a media blackout in the run-up to the Fed’s scheduled meeting next week.
“We have QE (quantitative easing) in Europe, a scaling back of rate expectations in the U.S. and Brexit fears — all the ingredients to hit new lows are there,” said Martin Van Vliet, a senior rates strategist at ING.
(Editing by Gareth Jones)