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* Ten-year BTP yield rises to 5.77 percent
* Italy sells 7.97 bln euros vs max target of 8.5 bln euros
* Investors demand high risk premium as debt worries weigh
(Adds details, analyst quotes after auction)
By Valentina Za
MILAN, July 28 (Reuters) - Italy's borrowing costs soared on Thursday as it sold nearly 8 billion euros of bonds, with jitters about its debt pile pushing its benchmark 10-year bond yield to the highest in 11 years.
The premium investors demand to hold 10-year Italian debt instead of safe-haven German Bunds widened after the auction and Italy's blue-chip index extended losses as analysts warned Rome could not afford to pay these kind of rates for a long time.
"These are not sustainable levels of yields in the long run," said Marc Ostwald, a bond strategist at Monument Securities in London.
A sell-off in Italian assets earlier this month on fears that the euro zone's third-biggest economy was being dragged into the debt crisis had eased somewhat after last week's agreement on a second bailout package for Greece.
But worries the euro zone crisis was far from resolved and may spread to Italy have returned to haunt its 1.6 trillion euro bond market this week.
With a debt burden of 120 percent of gross domestic product, anaemic growth and a fragile government, Italy is seen as vulnerable to contagion.
Just minutes after the Treasury had to pay a hefty risk premium to sell its bonds, a government minister dismissed rumours that Economy Minister Giulio Tremonti -- widely credited with keeping Italy's budget deficit in check -- was preparing to resign.
The auction gross yield on the 10-year bond rose to 5.77 percent, the highest since February 2000 and just a shade under a euro lifetime record of 5.81 percent.
The yield on a new three-year bond jumped to 4.80 percent, the highest since July 2008.
Still, Italy managed to sell nearly 8 billion euros of bonds against a maximum target of 8.5 billion euros -- a sign of healthy demand.
"It is positive that they sold nearly the full amount of BTPs. The bid-to-cover is not great but still in line with the last few auctions," said Alessandro Giansanti, a rate strategist at ING in Amsterdam.
"What's worrying is that the spread keeps rising, and so do the auction yields," he said.
The spread between the Italian 10-year BTP and the German Bund rose to 331 basis points after the auction after hitting a euro lifetime high of 353 basis points earlier this month.
At these levels, the spread is around 110 basis points higher than where it stood before the market sell-off started on July 8.
Deadlock in U.S. talks to avoid a possible debt default are also adding to investors' concerns.
Analysts say Italy can shoulder rising debt costs in the short term as the average life of 7.09 years on its debt helps smooth the impact of higher rates.
But they say the high premiums the market demands would threaten debt sustainability if they became entrenched. ($1=.6884 Euro)
(Additional reporting by Giulio Piovaccari and Alessia Pe; writing by Silvia Aloisi; Editing by Ron Askew)