By Marius Zaharia
LONDON, Sept 30 (Reuters) - Political instability put Italy's bonds under heavy 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.
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. Even if Letta manages to save this government, the market would take the view that it will all be very fragile.'
Ten-year Italian yields rose 25 basis points to 4.68 percent, expanding the gap over benchmark German Bund yields to the widest since end-June at just above 300 basis points.
According to Reuters data, Italian yields were on track for heir biggest daily rise in three months.
The government's failure to reform the electoral system means that holding new elections at this time might lead to another inconclusive result. Talks to form a government following a vote in February took two months.
Spanish and Irish 10-year bond yields rose about 4 basis points - a far more subdued move than during the episodes of contagion seen at the height of the euro zone debt crisis.
Analysts said Italian yields had to get closer to their crisis peaks of over 7 percent before its political risks spilled over and attributed the rise in other peripheral yields to aversion to risky assets stemming from the threat of a U.S. government shutdown.
On Sunday, the Republican-controlled House of Representatives passed a measure that ties government funding to a one-year delay of President Barack Obama's landmark healthcare restructuring law, while Senate Democrats have vowed to reject it.
Low-risk Bund futures rose 25 ticks to 140.70, while 10-year German yields fell 2 basis points to 1.71 percent.
'The risk (of a government shutdown) is more elevated ... but we're still confident there will be a compromise and I think this is the market view at the moment,' BNP Paribas rate strategist Patrick Jacq said.
(Editing by Jeremy Gaunt) Keywords: MARKETS BONDS/EURO
(firstname.lastname@example.org)(+44)(0)(207 542 0950)(Reuters Messaging: email@example.com)
Copyright Thomson Reuters 2013. All rights reserved.
The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.