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RPT-Big bond investors bet ECB will ride to Italy's rescue with QE package

(Repeats MARCH 11 story, no change to text)

* Aberdeen, Allianz GI, Franklin Templeton buy Italian debt

* ECB expected to ramp up QE asset purchases on Thursday

* Many funds also like longer Gilts after UK rate cut

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

By Dhara Ranasinghe and Tommy Wilkes

LONDON, March 11 (Reuters) - European bond investors have piled back into Italian bonds amid this week's sell-off, betting that the European Central Bank will on Thursday unveil a big increase in asset purchases and boost a market hit hard by panic over the coronavirus outbreak.

Yields on 10-year bonds yields in Italy, the country worst-affected by coronavirus outside China, have risen around 40 basis points in the past month as investors positioned for the outbreak to deal a heavy blow to the indebted economy.

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But several large investors told Reuters on Wednesday they were moving back into the market, believing the ECB was likely to follow other central banks and unveil several supportive measures when it meets on Thursday, including an increase in monthly asset purchases.

On Wednesday, Italian yields dropped nearly 20 basis points .

"It's clear that the Italian situation is dire, but as it's been proven in the past, the ECB has proven the most important driver of the Italian spread and clearly there is a lot of pressure building on the need to step up efforts, especially on QE (quantitative easing)," said Ross Hutchison, a rates fund manager at Aberdeen Standard Investments.

"We are still underweight Italian bonds, but have bought some bonds back recently on expectations for a ECB policy response," said Hutchison, part of the ASI rates team managing 30 billion pounds ($38.79 billion) worth of assets.

Trading volatile Italian debt has been popular among managers searching for yield in recent years, but the complex political situation and Rome's economic vulnerabilities have made it a tricky trade - and many managers have been caught out. Italy is currently in lockdown to tackle the coronavirus, and its economy is expected to slow sharply.

The ECB is widely expected to take action on Thursday to protect the euro zone economy. Major central banks including the Federal Reserve and Bank of England have already announced emergency rate cuts.

John Taylor, co-head of European fixed income at AllianceBernstein, said he expected the ECB to announce an increase in bond purchases to at least 40 billion euros ($45.04 billion) monthly.

The ECB currently buys 20 billion euros of bonds monthly. Its asset purchases, worth over 2.6 trillion euros since 2015, have pinned down bloc-wide borrowing costs.

"During the sell-off, we have returned to our overweight (position on Italy). We think spreads should come in," said Taylor.

The closely-watched gap between 10-year Italian and German government bonds on Tuesday rose to almost 230 bps - its widest in seven months - after blowing out by 50 bps in Monday's brutal selloff.

Taylor said he was targeting the spread to tighten back to 150 bps.

The ECB risked being "left behind" if it did not loosen policy. Knowing that a limited response would send the euro higher when the economy could not handle a stronger currency would drive the ECB to act, Taylor said.

David Zahn, head of European fixed income at Franklin Templeton, said Italian and Spanish bonds offered "good value" in a world of plunging government bond yields.

Key to a credible European response to deal with the coronavirus would be coordinated monetary and fiscal policy, Zahn said.

While he would normally worry about the euro area's ability to co-ordinate, he had been impressed by the European Union's display of unity on the virus so far.

Allianz Global Investors has also bought back into Italian debt, head of UK fixed income Mike Riddell said.

BOE HEADING FOR QE?

Several investors said they also saw value in British government bonds, known as gilts, especially longer-dated ones.

On Wednesday, the Bank of England slashed rates and announced support for bank lending just hours before the unveiling of a budget splurge.

Gilt yields have dropped sharply in the past week as expectations rose for an aggressive policy response to the outbreak.

"The front end of the gilt market cannot rally much more from where it is right now, but that doesn't mean gilts overall can't rally," said Allianz Global Investors' Riddell.

"The rate cut was not a surprise to the market, but what this means is that QE is far closer than the market anticipated just a few days ago."

Earlier this week short-dated gilt yields fell into negative territory for the first time. Thirty-year gilt yields are trading around 0.67%. ($1 = 0.8880 euros)

(Editing by Nick Zieminski)