January 10, 2018 / 12:39 PM / a year ago

UPDATE 1-Franklin Templeton's Zahn halves Italy exposure pre-vote, says watching Bank of Japan

* David Zahn reduces holdings of Italian bonds before election

* Still likes BTPs, looking to increase exposure in any sell-off

* Zahn says "quite important" to watch Bank of Japan (Updates with more details quotes)

By Dhara Ranasinghe

LONDON, Jan 10 (Reuters) - Franklin Templeton's David Zahn said on Wednesday he had halved holdings of Italian debt in his flagship fund amid expected pre-election volatility, although any selloff would be an opportunity to increase exposure to Italian bonds.

Italy will vote on March 4 in an election expected to produce a hung parliament, causing some concern among investors that it will cause instability and possible market turbulence in the euro zone's third largest economy.

"We've reduced the amount of bonds we have in Italy by roughly half in anticipation of the election volatility and we're looking to increase it again if that volatility comes to bear," said Zahn, referring to the flagship Franklin European Total Return Fund.

"We still fundamentally like Italy," he said.

Zahn is Franklin Templeton's head of European fixed income and manages more than 2 billion euros ($2.4 billion) of assets.

Italy's 10-year government bond yield has risen more than 30 basis points since mid-December when talk of a March election first emerged.

That has pushed out the gap over top-rated German peers to around 156 bps versus 136 bps a month ago.

Zahn said that in the run-up to the election, talk from eurosceptic parties on membership of the single-currency bloc could weigh on Italian bonds, but that once election risks had passed the market offered a "good return vis-à-vis the risks embedded."

Silvio Berlusconi said on Tuesday that Italy must not leave the euro, but his main coalition partner immediately disagreed, underlining policy differences in the centre-right bloc which is expected to take most seats in the election.

Zahn said watching for any changes in the Bank of Japan's monetary policy would also be important and could help steepen government bond yield curves in the euro area.

Speculation the Bank of Japan may wind back its monetary stimulus this year gripped markets on Tuesday after the central bank trimmed the amount of its purchases of long-dated Japanese government bonds.

"The Fed is starting to reduce its balance sheet, in Europe we're starting to reduce the amount of new QE and in Japan they still have their 10-year bond yield anchored," said Zahn.

"Watching the BOJ is quite important because if they start to move on that, that's the last major central bank liquidity provider disappearing. That would have an impact on Europe, and one way that would happen is to see steeper yield curves." (Reporting by Dhara Ranasinghe; Editing by Hugh Lawson)

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