Berlusconi comeback threatens Italian market rally
* Markets bet on centre-left victory
* Berlusconi's comeback seen hitting shares, bonds
* Investors would like Monti to play role in new govt
LONDON, Jan 16 (Reuters) - A sharp rally in Italian government bonds and shares could be in jeopardy as scandal-plagued former premier Silvio Berlusconi gains ground in polls, putting investors' bets on a centre-left election victory at risk.
A reform-friendly coalition of centre-left parties is still expected to win most seats at the Feb. 24-25 election, but recent polls showed a right-wing bloc led by Berlusconi was closing the gap.
With a debt mountain of around 2 trillion euros ($2.7 trillion) and the economy barely growing, analysts say Italy needs structural reforms and that the election could determine the pace at which they are implemented.
They worry that if Berlusconi's alliance wins, Italian debt may spiral out of control, throwing the country back into the deep end of Europe's debt crisis, just as it was when he resigned in November 2011.
Benchmark Italian bond yields have nearly halved and shares have gained 17 percent since Berlusconi was replaced by technocrat Mario Monti, helped by European Central Bank President Mario Draghi's pledge to buy the bonds of indebted euro zone states that request help.
While Monti's reform agenda and austerity policies improved the confidence of investors and euro zone governments in Italy's public finances, a return to power for Berlusconi could change that.
Martin Harvey, fund manager at Threadneedle Investments, said if Berlusconi were to win he might sell some of his Italian bonds, which currently account for 16 percent of his funds, more than the funds' benchmark index.
"It looks like the alliance involving Berlusconi will not have enough votes to gain power," he said. "If nearer the time it appears that there may be a less favourable outcome for the markets, we would have to consider reducing our position."
After pocketing returns of 20 percent on Italian bonds last year, a level surpassed only by bailed-out Greece, Portugal and Ireland, yield-hungry investors remain positioned for what many of them consider the most favourable outcome - a win by a coalition of centre-left parties led by Pier Luigi Bersani.
"You can't get the yields you need (in other markets), and there's certainly an elevated level of pressure to be invested in Italy," said David Schnautz, interest rate strategist at Commerzbank in New York.
"We don't expect markets to be overly worried unless we get Berlusconi back."
Bersani won investors' confidence by pledging to stick to the austerity programme prescribed by Monti.
Italy's borrowing costs hover near lows not seen since 2010, and Milan's main share index, the FTSE MIB, trades at a 17-month high, showing investors remain confident that the elections will not blow the country off the path of reform.
Joost van Lendeers, investment specialist for allocation and strategy at BNP Paribas Investment Partners, estimated the FTSE MIB could fall 5-10 percent if Berlusconi's bloc overtook the centre-left in polls.
He said stock would fall even more sharply if a Berlusconi-led government failed to make further progress on economic reforms, causing borrowing costs to rise and eventually pushing the country closer to requesting international help.
The yield spread between 10-year Italian bonds and benchmark German Bunds could spike up to 400 basis points from 275 bps now in an immediate reaction to that "unlikely scenario", ING strategist Alessandro Giansanti said.
Italy could find it difficult to borrow in the market with Berlusconi at its helm, he said.
Financial instruments used to insure against an Italian default and against swings in Milan-listed shares have ticked up since Berlusconi gained ground in polls this week, though they remain around multi-month lows .
While polls suggest Berlusconi's coalition is unlikely to regain power, it could win enough support to force the centre-left to seek a coalition with Monti, who is leading a centrist grouping.
Markets would view favourably a government including Monti, who was praised by analysts and fellow European leaders for keeping Italy's finances under control last year.
"The market seems to be working on the assumption that we'll get some kind of centrist coalition between the Democrats and Monti and the less favourable scenario of Berlusconi is a low probability," said Robin Marshall, fixed income director at Smith and Williamson securities, managing about $18 billion.
"The market has got the most favourable scenario priced in."