UPDATE 1-Yields up at Italian bill sale ahead of tougher auction test
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MILAN, Aug 28 (Reuters) - Italy's six-month borrowing costs rose slightly at auction on Wednesday as investors remained wary of turmoil in the country's fragile ruling coalition, ahead of a more challenging sale of longer-dated bonds on Thursday.
Steady domestic appetite for Italian bills helped the Treasury smoothly sell 8.5 billion euros in debt, meeting demand for nearly 1.5 times that amount, the same as at a previous auction a month ago.
Yields rose to 0.89 percent from 0.80 percent in July.
"Thursday's auction will tell us how international investors are reacting to domestic political risk in Italy and geo-political developments," said ING strategist Alessandro Giansanti.
The governing coalition is struggling to bridge differences over a housing tax that threatens to create a new crisis for an administration already severely strained by the legal turmoil surrounding Silvio Berlusconi.
The possibility of Western military action against the Syrian government has also hurt Italian bonds by pushing investors to favour less risky assets.
"This week's auctions of short-dated Italian paper have gone well thanks to domestic investors, but sales of longer-dated bonds test the appetite of international buyers," he said.
On Tuesday, Italy raised 3.98 billion euros at an auction of zero-coupon and inflation-linked paper.
Analysts say investor mood will likely be influenced by the outcome of cabinet meeting later on Wednesday called to find an accord over changes to the controversial property tax.
Its cancellation, demanded by the centre-right PDL party, would force the government to fill a financing gap of 4 billion euros a year.
Italy offers up to 6 billion euros in bonds on Thursday, including a new five-year benchmark maturing in December 2018 and a further tranche of its 10-year one.
The March 2024 bond to be auctioned yielded 4.54 percent in late morning trade on Wednesday, suggesting a possible slight rise in borrowing costs from the last auction when it was priced at 4.46 percent.
The risk premium Italian 10-year bonds pay over safer German Bunds is at its highest since the beginning of August at 261 basis points.
Italian bonds have also underperformed Spanish ones lately due to the domestic political uncertainty. The premium 10-year Spanish bonds offer over Italian ones hit a low since March 2012 on Tuesday at 4 basis points, before widening again slightly on Wednesday.
"At the very short end Spain trades well through Italy," UniCredit strategist Luca Cazzulani said, pointing to yields on a three-month maturity.
"The political situation in Italy will dictate whether or not the same will happen also to longer-dated maturities, which right now are roughly flat. Based on fundamentals I don't see reasons to back Spain's outperformance."
The row over the housing tax as well as the political future of centre-right leader Berlusconi has rocked the right-left coalition, casting a shadow over the early signs of improvement in an economy still mired in its longest post-war recession.
Some of Berlusconi's hardline allies have threatened to bring down the government if he is expelled from parliament following a conviction for tax fraud.
(Additional reporting by Giulio Piovaccaria and Irene Chiappisi,; editing by James Mackenzie and Toby Chopra)