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Telefonica to use exchangeable bond to cut Telecom Italia stake

* 750 mln euro bond converts to Telecom Italia shares in 3 years

* Marks first time Telefonica sells Telecom shares

* Telefonica is Telecom's biggest shareholder with 14.8 pct

* Telecom chairman sees no strategy change (adds comment from Telecom Italia Chairman)

By Julien Toyer and Leila Abboud

MADRID/PARIS, July 16 (Reuters) - Telefonica will sell 750 million euros ($1 billion) in bonds that convert to Telecom Italia shares, it said on Wednesday, effectively loosening its grip as largest shareholder.

In a notice to Spain's market regulator, Telefonica said the bonds, which pay 5.25 to 6 percent interest a year, would mature in three years but could be converted at any time before that or paid in cash if conditions are met.

The mandatory exchangeable bond is a way for Telefonica to reduce its 15 percent stake in Telecom Italia by about 5 percent, said a person close to the transaction.

It could also be a first step towards a full exit from the Italian carrier, although Telefonica has not made a decision on that issue, said another person familiar with the company's thinking.

A Telefonica spokesman declined to comment.

"This is a way for Telefonica to sell part of its stake in Telecom Italia while ensuring against downside risk if the shares lose value in the next three years," said the first person.

The bond issue will be coordinated by HSBC Bank, JP Morgan Securities and Societe Generale.

The move is the latest in a series of changes to the ownership and board of Telecom Italia in recent months, touched off by the desire of key shareholders to exit.

Italy's Assicurazioni Generali, Intesa Sanpaolo and Mediobanca took first steps last month to dissolve a seven-year shareholder pact with Telefonica that controlled Telecom Italia, making way for new investors in the phone company.

The Italian groups plan to get rid of their stakes in Telecom Italia in the coming months by selling shares on the market.

Telefonica has also been under pressure from Brazilian competition regulator CADE for the influence it has over Telecom Italia, which owns Brazil's second largest mobile operator TIM Participacoes. Telefonica owns and operates Brazil's leading mobile carrier Vivo, which CADE sees as a conflict.

In December CADE ordered Telefonica to either sell its interest in Telecom Italia, or seek a new partner for Vivo and gave it 18 months to comply.

At that time, Telefonica's preferred option was to engineer a sale of TIM by Telecom Italia, breaking up the mobile operator and dividing its assets and network between itself and the other two mobile operators in Brazil, America Movil and Oi.

An analyst at an international brokerage said the bond could help Telefonica appease the competition regulator in Brazil and may allow the Spanish group to pursue its planned break up of TIM.

The exchangeable bond "is invariably going to lead people to ask what Telefonica plans to do with the rest of its stake in Telecom Italia," said a third person close to the deal.

"After all this is the first time Telefonica has started to sell its Telecom Italia shares."

Telecom Italia Chairman Giuseppe Recchi told Reuters that the move by Telefonica would not affect the Italian group's own strategy.

Telefonica shares closed up 1.4 percent to 12.28 euros, in line with the European telecoms index.

Telecom Italia's were up 7.5 percent to 0.91 euros, a rise that traders said was driven by hopes of mobile consolidation. in Brazil.

($1 = 0.7393 Euros) (Additional reporting by Danilo Masoni in Milan; Editing by Sarah White/Ruth Pitchford)