* Italy-Germany bond yield spread comes off recent narrow levels
* Deal to add up to 17 billion euros to outstanding state debt
* Centre-right parties main winners in Italian mayoral elections
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr
By Abhinav Ramnarayan
LONDON, June 26 (Reuters) - Italian government bond yields rose on Monday after the European Commission approved the rescue of assets of two struggling Veneto banks, ending months of speculation over whether Italy would be able to bypass regulations preventing state bailouts of banks.
Italy began winding up two failed regional banks on Sunday in a deal that could cost the state up to 17 billion euros ($19 billion) and will leave the lenders’ good assets in the hands of the nation’s biggest retail bank, Intesa Sanpaolo.
The yield on Italy’s 10-year debt came off recent lows on the news - given that it means the country’s debt level will rise - but the increase was capped by relief that a banking crisis would probably be averted.
“There is the danger that other banks need state support, but I think there’s more clarity now that there is a solution for the banking sector,” said ING strategist Martin van Vliet.
Italy’s bond yield spread over Germany widened to 168 basis points on Monday, off last week’s low of 160.5 bps but well below this month’s peak of 203.5 basis points.
BBVA strategists believe that if the entire 17 billion euros is used, it would add about 1 percentage point to the country’s debt as a percentage of its economic output. Italy’s debt-to-GDP ratio is among the highest in the world at 132.6 percent at the end of 2016, according to EU data.
Though the strategists believe the addition to the debt burden is offset by the end of uncertainty on this issue, they warned there may be more issues surrounding the sector.
“We should recall that this will not be the end of the noise about the banking system affecting the sovereign as there still remain some issues with Banca Cariage as well as some pending issues with Monte di Paschi di Siena,” they said in a note.
Italy was also in the news on the political front, its centre-right parties proving the big winners in mayoral elections on Sunday, partial results showed.
The vote is likely to put pressure on the centre-left government ahead of national elections due in less than a year.
Later on Monday, European Central Bank chief Mario Draghi is due to speak, at a time when investors are looking for clues on when the bank will end its ultra-loose monetary policy stance.
Most high-grade euro zone bond yields were unchanged on Monday, with 10-year German bond yields edging lower to 0.25 percent.
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Editing by Ed Osmond