* Tax accord helps sentiment but political worries remain
* PM Letta says Berlusconi legal worries do not threaten stability
* Bond auction sees 10 year yields stable, 5-year yields rise
By Valentina Za
MILAN, Aug 29 (Reuters) - Agreement to scrap an unpopular housing tax which had threatened the stability of Italy's fragile government helped smooth a bond sale on Thursday but political tensions meant it came at a cost.
Ten year borrowing costs remained stable but wary investors demanded a higher premium to buy a new five year bond as the Treasury sold the maximum planned amount of six billion euros set aside for the auction.
"The market has breathed a sigh of relief but political risks will continue to weigh on Italian bonds," said Luca Jellinek, an analyst with Credit Agricole, warning that former premier Silvio Berlusconi's legal battles and question marks over how to pay for the housing tax cut would dampen sentiment.
The government agreed on Wednesday to scrap the IMU tax on primary residences, easing a source of persistent tension which had risked splitting Prime Minister Enrico Letta's coalition of rivals from the left and right.
Financial markets, increasingly twitchy over the past week, reacted positively with the main barometer of sentiment, the spread between Italian 10 year bonds and safer German Bunds narrowing 10 basis points to 251 points.
Shares in Berlusconi's media company Mediaset rose 5 percent.
Although the deal on IMU has eased fears of a government collapse and new elections, the coalition faces a fresh test over the political future of Berlusconi following his conviction for tax fraud earlier this month.
The billionaire media tycoon and centre-right leader is fighting to stay in parliament ahead of a probable vote on expelling him from the Senate, but Letta dismissed fears that the legal battle could create a fresh crisis.
"I'm not worried that there will be any impact on the survival of the government, especially now, from issues related to sentences or judicial cases," he told RAI state radio.
Berlusconi's allies hailed the accord, which will see the IMU replaced by a new local services levy from next year. But reaction elsewhere was more muted, with questions over how to fill the 4 billion euro funding gap that has been created.
Former Prime Minister Mario Monti, whose technocrat government created the tax in 2011 as it sought to stave off a Greek-style debt crisis, said Letta and the centre-left Democratic Party (PD) had caved into PDL threats.
"Letta and the PD have shown clearly that unfortunately, intimidation pays," he told Rainews24.
Thursday's auction was the first concrete test of market reaction for the government, which is trying to manage a two trillion euro public debt burden while the economy struggles to emerge from its longest postwar recession.
It gained some encouragement from an unexpectedly strong rise in business confidence after growing signs that the economy may start to turn around.
The Treasury, which has met 75 percent of this year's 450 billion euro funding target, sold 2.5 billion euros of a 10-year bond at an unchanged 4.46 percent yield. Demand totalled 1.5 times that amount, up from 1.3 times a month ago.
It also sold 3.5 billion euros of a new bond maturing in December 2018 at 3.38 percent but saw the yield rise from 3.22 percent a month ago. The sale was covered 1.2 times, down from 1.4 times in July.
"The 10-year sale went well, helped by the small amount on offer. The five-year one did not go that well despite the limited amount," ING rate strategist Alessandro Giansanti said.
To plug the revenue hole from the scrapping of IMU Letta plans tax hikes on gambling and higher sales-tax revenues from firms benefiting from an acceleration of back-payments owed by the public sector. But details have not been finalised.
Further spending cuts will be decided in the budget law in October, while a new "Service Tax", combining a levy on principal residences with one on waste disposal, will be introduced from next year.
European Monetary Affairs Commissioner Olli Rehn said the Commission still needed to see details and said Italy must stick to its pledge of keeping its budget deficit within three percent of gross domestic product.