* Stability of Italian government put to test
* Italy returns to market this week after summer break
* Bund yields off 1-1/2 year highs before Ifo release
By Marius Zaharia
LONDON, Aug 27 (Reuters) - Italian bond yields rose on Tuesday as tensions within the country’s fragile ruling coalition have grown just as it prepares to return to debt markets after a summer break.
Disagreement over a housing tax and a looming vote on whether to expel former premier Silvio Berlusconi from parliament after he was convicted of tax fraud have raised worries about the stability of Italy’s government.
Prime Minister Enrico Letta has set a deadline of a government meeting on Wednesday for a deal on the housing tax, while a Senate committee is due to begin hearing arguments on Berlusconi’s case on Sept. 9.
Italian 10-year bond yields rose 4 basis points on the day to 4.43 percent, widening the gap over benchmark German Bund yields to 254 basis points.
“A combination of lingering worries over the ruling coalition and concession ahead of upcoming supply suggests Italy will struggle to make any headway near-term,” RIA Capital Markets strategist Nick Stamenkovic said.
Italy will offer up to 3 billion euros of zero-coupon bonds (CTZ) and up to 1 billion euros of bonds linked to euro zone inflation on Tuesday, but the real test of sentiment will be a sale of up to 6 billion of five- and 10-year bonds on Thursday.
Spain’s 10-year yields also rose 4 bps on the day to 4.51 percent, with traders citing profit taking on bets Spain would outperform Italy after the yield gap between the two tightened to its narrowest in 1-1/2 years at 8 bps on Monday.
“We saw a strong underperformance of BTPs (Italian bonds) over Bonos (Spanish bonds) probably on the back of political tensions in Italy, so the auctions will be very important to also see the primary market’s reaction to that,” BNP Paribas rate strategist Patrick Jacq said.
Bund futures were last 8 ticks higher on the day at 140.13, with cash 10-year German yields a touch lower at 1.89 percent - just off 1-1/2 year highs of 1.98 percent hit last week.
German yields have risen sharply in recent weeks on expectations that an improved global economic outlook could prompt the Federal Reserve to reduce monetary stimulus in September, while other major central banks might struggle to keep their promise to keep interest rates low for a long time.
The Ifo business sentiment survey will provide more clues about the state of the German economy at 0800 GMT.
The Ifo index is expected to rise to 107 in August from 106.2 last month, a Reuters poll showed, but concerns the United States was inching towards military action against Syria over a suspected chemical weapons attack gave some support to safe-haven assets.