By Marius Zaharia
LONDON (Reuters) - Political instability put Italy's bonds under heavy selling pressure on Monday after five ministers from former premier Silvio Berlusconi's party stepped down at the weekend, increasing the risk of new elections.
Yields rose and were at a three-month high over safe haven German equivalents. The cost of insuring Italian debt against default also climbed. Both remained well off crisis levels, however.
The resignations were set off by clashes at a Friday cabinet meeting over an imminent sales tax hike.
Italian Prime Minister Enrico Letta will go before parliament on Wednesday and hold a confidence vote to verify what is left of his parliamentary backing. President Giorgio Napolitano began talks on Sunday to solve the crisis.
Tensions have been running high in Letta's left-right coalition ever since last month, when Berlusconi was convicted of tax fraud. His allies have threatened to bring the government down if he was ousted from parliament following his conviction.
"New elections are more likely and this is not good news when it comes to reforms," Commerzbank rate strategist Michael Leister said. "This has become a structural issue in Italy."
Ten-year Italian yields were last 23 basis points higher at 4.65 percent, having earlier risen by more than 30 bps to expand the gap over benchmark German Bund yields to the widest since end-June at just above 300 bps. According to Reuters data, Italian yields were on track for their biggest daily rise in three months.
The cost to insure Italian debt against default via five-year credit default swaps rose 16 basis points to 280 bps - the highest since early July, according to data monitor Markit.
Holding new elections might lead to another inconclusive result. Talks to form a government following the vote in February took two months.
LIMITED CONTAGION RISK
Spanish and Irish 10-year bonds, which have fallen victims of Italian political crises during the euro zone debt crisis, saw flat-to-slightly-higher yields on Monday.
Analysts said Italian yields had to get closer to their crisis peaks of over 7 percent before its political risks spilled over, but they did not expect such a move. After the February vote, yields failed to sustainably break 5 percent.
Governments and policymakers are also better positioned to deal with renewed tensions.
Italy and Spain have already completed more than 80 percent of their funding plan for this year and domestic investors, who tend to hold assets for longer than foreign investors do, hold two-thirds of the tradeable debt in both markets.
Also, the European Central Bank's conditional promise to buy government bonds, so far untested, still has a prophylactic effect on crisis flare-ups.
"It's not as black or white as it was at the beginning of the crisis. Investors differentiate much more," DZ Bank strategist Christian Lenk said.
Analysts attributed the minor rise in other peripheral yields to aversion to riskier assets stemming from the threat - still regarded as limited - of a U.S. government shutdown.
The Republican-controlled House of Representatives passed a measure on Sunday that ties government funding to a one-year delay of President Barack Obama's landmark healthcare law, while Senate Democrats have vowed to reject it.
Bund futures rose 11 ticks to 140.56, while 10-year German yields dipped 1 bp to 1.72 percent.
"The risk (of a government shutdown) is more elevated ... but we're still confident there will be a compromise," BNP Paribas rate strategist Patrick Jacq said.
(Editing by Jeremy Gaunt)