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Italy's three-year borrowing cost highest in nearly a year

MILAN (Reuters) - Italy paid the most in nearly a year to sell three-year paper at auction on Thursday as political tensions persisted and as yields on riskier assets rise in anticipation of a gradual withdrawal of U.S. stimulus.

Italian debt has underperformed that of Spain in recent days ahead of a decision on the political future of former premier Silvio Berlusconi that could bring down the government. Pressure in markets has so far been muted, although Prime Minister Enrico Letta warned on Wednesday that the political turmoil was driving borrowing costs up.

The Treasury sold 4 billion euros of a new three-year bond, the maximum planned amount, at an average 2.7 percent yield. This was up from 2.3 percent at a previous mid-July auction, but well below a peak of more than 5 percent hit at the beginning of last year's turbulent summer.

The bond sale came hours before a Senate committee resumes a debate on whether to expel Berlusconi from parliament after a tax fraud conviction, a decision which is threatening the survival of Letta's fragile governing coalition.

"The Berlusconi factor seems to be a permanent fixture of Italy's political landscape and is now pushing premier Enrico Letta's conflict-ridden coalition government to the brink of collapse," said Spiro Sovereign Strategy director Nicholas Spiro.

"While there is no sign of panic in Italy's bond market, the strains have been showing for some time."

Italy raised the maximum planned amount of 7.5 billion euros at the sale, which included a 15-year bond and two floating-rate bonds maturing in 2018.

The three-year bond was covered 1.5 times, up from 1.3 times at the July sale, as rising yields spurred domestic bids.

Italy paid 4.9 percent to sell 1.5 billion euros of a September 2028 bond. It had last sold the same bond at an average 4.7 percent yield in June. The bid-to-cover ratio for this bond dropped to 1.4 times from 1.7.

Tensions within the government coalition have pushed yields on Italian bonds above Spanish ones this week for the first time since March 2012. On Wednesday, Italy paid the highest yield in nine months to sell one-year paper.

Expectations that the U.S. Federal Reserve will begin scaling back its bond-buying with newly printed money this month are also weighing on riskier assets including Italian debt.

Letta said on Wednesday that political instability had a "heavy" cost for Italy's two-trillion euro debt which makes the country the world's fourth-largest debtor.

Italy's slow emergence from a protracted economic crisis is also making investors cautious. The European Central Bank said on Thursday the country faces increased risks of missing its 2.9 percent of GDP deficit target as it may need to borrow more this year than initially thought.

Italy plans to up the ceiling on 2013 net debt issuance by more than a fifth to 98 billion euros.

Analysts see early elections as unlikely but say a government reshuffle is possible. It would come at a time when Italy is due to draft next year's budget, seeking to contain a public debt already projected at 130 percent of output.

Italy will update its budget forecasts next week.

(Reporting by Valentina Za and Lisa Jucca; Editing by Catherine Evans)