UPDATE 1-Domestic demand helps Italy keep lid on rising yields
(Adds comments from analysts, details)
MILAN, Aug 27 (Reuters) - Demand from domestic investors helped Italy to keep a lid on rising borrowing costs at an auction on Tuesday, paying only slightly more than a month ago to sell two-year bonds despite political turmoil.
Italy paid 1.87 percent to sell 2.98 billion euros of a zero-coupon bond due in June 2015, only fractionally up from 1.86 percent at a similar auction a month ago. The sale was covered 1.5 times, compared with 1.6 times at the end of July.
The rise in Italian yields, albeit small, contrasted with lower yields on Tuesday at a T-bill auction in fellow euro zone struggler Spain. Madrid's 10-year spread over Rome hit at an 18-month low of just 8 basis points on Monday.
"The (Italian) auction can be considered satisfactory overall, given that the backdrop is not that favourable at the moment," said Vincenzo Longo, a strategist at IG Markets.
He warned however that the treasury faced a bigger challenge on Thursday when it will sell up to 6 billion euros of 5- and 10-year bonds.
"The focus turns now ... on Thursday's bond sale because then political uncertainty could hit demand from international investors," he said.
Italy traditionally relies on strong domestic support, particularly at the short end of the curve.
"Domestic investors and banks have probably taken advantage of the recent rise in yields to buy," said ING strategist Alessandro Giansanti.
The Treasury also sold 1 billion euros of inflation-linked bonds on Tuesday, bringing the total near the top planned amount of 4 billion euros. It returns to the market on Wednesday with an 8.5 billion euro auction of six-month bills.
Earlier this month Italian and other lower-rated euro zone bonds benefited from the first signs of an economic recovery, encouraging investors to buy riskier assets, but the threat of a government crisis has again pushed up risk premiums on Italian bonds.
The two main parties in the coalition supporting the government of Italian Prime Minister Enrico Letta are at loggerheads over whether to expel former premier Silvio Berlusconi from parliament following a tax fraud conviction and whether to abolish an unpopular housing tax.
Berlusconi's allies have said his explusion would be unacceptable, threatening to bring down the government.
Adding to Letta's woes, a cabinet meeting on Wednesday is set to decide on changes to the property tax, whose cancellation is demanded by Berlusconi's party, a move that would risk creating a hole in Italy's strained public finances.
On Tuesday, the yields on the two inflation-linked bonds fell compared with the last auction at the end of June, when the U.S. central bank signalled it would slow the pace of its bond purchases, sending bond yields sharply higher.
A five-year linker due in 2018 was sold at an average 2.3 percent yield, down from 2.9 percent in June. A 15-year 2026 linker fetched an average 3.3 percent yield, down from 3.8 percent.
(Reporting by Valentina Za, Gabriella Bruschi and Giulio Piovaccari; editing by Silvia Aloisi)