LONDON: German government bonds fell on Monday on expectations Europe will sign off on a second Greek bailout package, but losses were expected to be limited given Greece's underlying economic problems.
Bund yields, although higher, were below the 2 percent level that has been an upper boundary this year. An agreement could see another test of this level in the short term but markets remain concerned about Greece's ability to implement necessary reforms, despite politicians' pledges.
Euro zone finance ministers are expected to approve the aid at a meeting later in the day, enabling the country to restructure its debt and avoid a disorderly default, a risk that has rattled financial markets in recent weeks.
But investors have been disappointed many times as deadlines have been pushed back while details of the agreement will be pored over to see if Greece can be put on sustainable footing.
"Once the risk of default is off the table markets will be happy with that for now and move on to the next thing, at least until a later date," a trader said.
"But if we come in tomorrow morning and there's no deal and we're still in the same situation we're going to see Bunds jump."
Portuguese bonds came under early pressure on concerns the Greek plan could mean private bondholders face subordination - being pushed down the queue for repayment in the event of a default - on their holdings.
Although the European Central Bank has said it may take losses on Greek bonds held in national central banks' investment portfolios, it is believed to have cut a deal to protect bonds bought under its Securities Market Programme from forced losses.
Investors are not ruling out the possibility that Portugal may also have to restructure its debt at some point.
"What's happening with the ECB is something that you don't want to see as a private creditor," said ING rate strategist Alessandro Giansanti.
"Starting with Greece, but even with Portugal, the weight of the official lenders is becoming bigger and bigger."
Yields on Spanish and Italian bonds fell but the worry about subordination kept the wider periphery in check. Italian 10-year yields were 10 basis points lower at 5.49 percent with equivalent Spanish yields down a similar amount.
A relative lack of supply from peripheral issuers this week was also supportive.
March Bund futures were 50 ticks lower at 137.92 with the break below Wednesday's 138.15 low, if sustained, potentially opening the way for Bunds to test the February 9 low of 136.93, said UBS technical analyst Richard Adcock.
Ten-year cash yields were 4 bps higher at 1.97 percent. Yields have been caught in a range of about 30 ticks this year, failing to hold above 2 percent the two times it has been tested.
"There are a lot of conditions for Greece to meet and that means a lot of chances to fail," a second trader said.
"So we're looking at short-term losses for Bunds but it still feels rangebound. Positioning is pretty square in the periphery and it doesn't seem as though people are particularly long of Bunds."
An easing of monetary policy by China on Saturday also added to appetite for riskier assets, pushing European equities to a near seven-month high and weighing on safe-haven government debt.
Trading was subdued with US markets closed for a holiday, potentially exaggerating any price moves.