* Premier Enrico Etta to meet president on political crisis
* Italy 10-year yields at 3-month highs at auction
* Italy 10-year yields inch back above Spanish equivalents
* Bund futures rally on Italy woes, U.S. debt cliff-hanger
By Emelia Sithole-Matarise
LONDON, Sept 27 (Reuters) - Italian yields and default insurance costs rose on Friday as resurgent political tensions in Rome hurt investor demand for bonds issued by the euro zone's third largest economy.
Rome's 10-year borrowing costs rose to their highest in three months at an auction of 6 billion euros ($8 billion) of bonds. Demand as measured by bid/cover was 1.4 for the 10-year bond compared with 1.5 at the end of August.
Italian bonds are under strain from renewed threats by Silvio Berlusconi's centre-right party to pull out of the coalition if the former premier is ejected from parliament in a Senate committee vote due next week.
Prime Minister Enrico Letta is expected to meet President Giorgio Napolitano on Friday to discuss the standoff over Berlusconi's conviction for tax fraud last month.
The country's fractious government will also try to work out how to avert a planned rise in sales tax while reining in a budget deficit which is overshooting European Union limits. Berlusconi's party has threatened to walk out if the tax goes into effect.
Italian bonds underperformed other euro zone debt after the auction, with its 10-year yields rising 7 basis points to trade back above Spanish ones at 4.41 percent. Spanish equivalents were 4 bps up at 4.38 percent.
"We thought there might be better domestic buying but the coincidence of political uncertainty and that it's quarter end generally limits banks' ability to take down large commissions. That combined to get a weak auction," a trader said.
"There's some selling coming through now and Italian bonds are going to remain weak until we get some clarity on the political situation," he added.
The premium paid by 10-year Italian debt over German benchmarks rose 11 bps to its highest in nearly a month at 267 bps. The cost of insuring Italian debt against default was up 4 bps at 250 bps, the highest since July 23, according to data provider Markit.
The flare-up of political tensions is reinforcing investor doubts about Italy's ability to pursue fiscal reforms, after Letta's government was forced by the centre-right party to climb down on a property tax last month.
"What's worrying people is the fact that the rating agencies have linked Italy's rating to their ability to pass financial reforms and if ... they start to suspect the Italian government is incapable of passing the necessary financial reforms then a downgrade could be in the offing," the trader said.
These concerns are seen driving Italian yields further above Spanish ones in coming days.
Spanish yields fell below Italy's for the first time in 18 months earlier in September but Italian bonds had clawed back ground over the past week after Berlusconi seemed to step back from threats to topple the government.
"The increased uncertainty surrounding the current government and the risk of a potential stalemate that it could entail do not seem to be priced in by the markets yet, notwithstanding the significant underperformance of BTPs," said Sunrise Brokers hed of fixed income research Gianluca Ziglio.
The softer tone in lower-rated euro zone debt and riskier assets spurred demand for safe-haven German Bunds. Bund futures were last 7 ticks lower at 139.80 and cash 10-year yields 0.7 bps up at 1.78 percent.
A potential U.S. government shutdown on Oct. 1 should budget negotiations in Washington reach an impasse also underpinned Bunds, but investors were refraining from extending positions before next week's European Central Bank policy meeting and U.S. non-farm payrolls report.