* Periphery rallies, Bunds fall after ESM gets green light * Spanish bond gains limited by scale of recent rally * German debt auction stutters as risk appetite picks up By William James LONDON, Sept 12 (Reuters) - Spanish and Italian bonds rallied and German debt prices fell on Wednesday after Germany's top court gave the green light to the euro zone's new bailout fund, prompting relief the bloc's rescue plans remained on track. The constitutional court rejected a challenge to the European Stability Mechanism (ESM), allowing Germany to ratify the fund as long as it can guarantee there will be no increase in German financial exposure to the fund without parliament's approval. The verdict was broadly as expected and the positive reaction in Spanish and Italian debt was limited by the scale of the rally in the weeks since the European Central Bank pledged to buy peripheral debt to lower sovereign borrowing costs. The Spanish 10-year yield was down 7.5 basis points on the day at 5.65 percent, compared with 5.71 percent before the ruling. In late July, the yield hit an unsustainable 7.8 percent. The equivalent Italian yield was down 3 bps at 5.06 percent having earlier sunk to within a whisker of 5 percent - a level last seen in March. The participation of the euro zone's rescue funds is a key condition of the ECB's support, and its approval removes a potentially major obstacle to resolving the debt crisis. "From a market point of view (the ruling) gives some certainty that it will continue down the route that has been started and it doesn't throw everything into chaos," said Elizabeth Afseth, strategist at Investec in London. So grave were the potential consequences of the court ruling against the ESM that some caution had been priced into core markets and as those positions quickly unwound German December Bund futures hit a 10-week low of 139.24, down over a point on the day. BUND SALE STRUGGLES The market's revived appetite for higher-yielding, more risky assets made for a difficult sale of German bonds - the lowest yielding debt in the euro zone. The launch of a new five-year bond carrying a 0.5 percent coupon received sufficient demand, but the quantity and quality of bids was below-par, reflecting a growing reluctance to accept the slim yields German debt offers. "If tensions in the single currency start to ease, particularly in peripherals, then the safe-haven allure of German bonds is going to soften. Consequently investors might start to demand higher yields at future auctions," said Nick Stamenkovic, strategist at RIA Capital Markets. At the opposite end of the credit spectrum, Italy sold 9 billion euros of 12-month treasury bills at a gross yield of 1.692 percent, its lowest since March 2012. Investors will now be watching Dutch elections to gauge the likelihood of the Netherlands remaining committed to austerity targets. Polls show the two main pro-European parties tied and, while a coalition is likely, questions remain over how quickly a new government can be formed. Rabobank recommended trading on the short-term uncertainty by positioning for the 10-year yield spread between Dutch and German bonds to widen to 41 bps. The spread was last at 31 bps.

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