UPDATE 2-Italian bonds yield more than Greece's for first time since 2008

(Updates prices, adds chart)

LONDON, Nov 7 (Reuters) - Italy’s bond yields rose above those of three-time bailout recipient Greece on Thursday for the first time in more than a decade, amid expectations that political uncertainty will return in Italy and economic reforms had taken hold in Greece.

Greece’s 10-year bond yields were 5.1 basis points lower than those of Italy. At the start of the year Greece’s yield was 164 bps higher than Italy’s. Greek debt had been higher yielding than Italian debt since early 2008.

Bond yields are a measure of how much interest a government has to pay investors to borrow. Greece and Italy have the highest debt levels as a share of economic output in the euro zone, but unlike Greece, Italy has not required a bailout.

Greece, which emerged only last year from its third bailout since 2010 after it was driven to the brink of collapse in a sovereign debt crisis, has seen its bonds rally all year. A credit rating upgrade from S&P to BB- with a positive outlook on Oct. 25 has provided an extra boost, so further upgrades may follow.

The euro zone’s rescue fund has also agreed to allow Greece to repay early some of its debt to the International Monetary Fund, on which it pays higher interest than current market rates, providing a further boost.

If Greece’s economic reforms continue and its rating is raised to investment grade, “the big difference” would be that its debt could be bought by the European Central Bank, Didier Saint Georges, managing director at asset manager Carmignac, told the Reuters asset allocation summit.

“We’re not there yet, clearly, but that’s where the markets are in terms of trajectory.”

Meanwhile, investors have grown doubtful about the future of the government of Italy, where growth has been stagnant and debt relative to gross domestic product is expected to rise this year.

At the same rating review, S&P kept Italy at a BBB rating with a negative outlook.

Since S&P’s rating review, Italian 10-year yields are up 17 bps, while Greece’s have risen a mere 2 bps.

Italy’s anti-establishment 5-Star Movement and centre-left Democratic Party formed a new government in September, which calmed investors’ nerves, but some now think that coalition might break down in the near future. Victory for the far-right League in a regional election in late October did not help.

“A majority of investors and market participants are still expecting that some political uncertainty will come back,” said Sebastian Fellechner, rates strategist at DZ Bank.

Some think the coalition government “is not a long-term deal,” Fellechner said, adding that he expects the Greek-Italian yield spread to remain volatile in the coming weeks and even months.

Reporting by Olga Cotaga, additional reporting by Sujata Rao Editing by Yoruk Bahceli, Larry King, Peter Graff