Rise in Italian bond yields checked as early election seen unlikely

* Italy bond yields rise 14 bps after 'No', then pull back

* Renzi vows to resign but snap election seen less likely

* Euro rebounds from 21-month low

* DBRS says Renzi resignation negative for key Italy rating (Adds quotes, updates prices)

By Dhara Ranasinghe and Abhinav Ramnarayan

LONDON, Dec (Shanghai: 600875.SS - news) 5 (Reuters) - Italy's borrowing costs rose on Monday after Prime Minister Matteo Renzi said he would resign following a crushing referendum defeat, although expectations that a snap election would be averted helped contain the sell-off.

Investors had been positioned for a 'No' vote in Sunday's referendum, but signs that investors were closing short positions across Italian assets and the euro, which bounced back from 21-month lows, lent bond markets some support.

Allianz Global Investors said it had reduced its short position on Italian government bonds on expectations an interim government would fill the void set to be left by Renzi.

A recent rise in outstanding contracts in Italian government bond futures, a tell-tale sign of shorting when coupled with price falls, kicked into reverse last week in a sign that others were scaling back bets against Italian debt.

David Zahn, the head of European fixed income at Franklin Templeton, said that at current yields - around 2 percent on 10-year paper - Italian bonds looked attractive and he would consider reducing an underweight position.

"The referendum does bring some clarity and we don't have that hanging over us any more. Now (Frankfurt: 11N.F - news) it depends on what the government decides to do," Zahn said. "I don't envision we will have early elections in Italy."

Renzi's constitutional reform was rejected by 59.1 percent of voters, a wider margin than had been expected. The resounding 'No' vote follows Britain's decision to quit the European Union in June and the unexpected election of Donald Trump as the next U.S. president last month.

VOLATILE

Italy is teetering on the brink of a rating downgrade that could raise costs in its beleagured banking sector.

Ratings firm DBRS said Renzi's exit was "negative" for Italy's A(low) rank, which allows banks to receive favourable funding rates from the European Central Bank.

Italian shares were volatile, dipping in and out of the red. Shares (Berlin: DI6.BE - news) in the country's third largest lender Monte dei Paschi (Milan: BMPS.MI - news) - currently trying to persuade investors to back an emergency recapitalisation - fell 6 percent, while an index of Italian bank shares fell 2.5 percent.

The link between Italy's banks and bond market is a major concern for investors. Banks, which hold large amounts of government debt, have been hit by worries over their exposure to bad loans built up during years of economic downturn.

Italy's 10-year government bond yield shot up as much as 14 basis points (bps) to 2.07 percent, but closed at 1.98 percent and held below a 14-month high of 2.17 percent touched in late November.

German 10-year yields - the euro zone benchmark - initially fell as the referendum results boosted demand for safe-haven bonds, but soon reversed track to close up 5 bps at 0.33 percent .

The market impact was limited as focus turned to Thursday's meeting of the European Central Bank and expectations that it would provide supportive rhetoric.

Sources told Reuters last week the ECB was ready to buy more Italian bonds if the referendum results unsettled markets. However, there were no signs of unusual ECB buying on Monday, traders said.

NO EARLY ELECTION?

Some analysts had said before the vote that defeat for Renzi could lead to a snap election that could see the anti-euro 5-Star Movement gain power. On Monday, however, many appeared to lean towards less political uncertainty.

"Most market participants don't expect an early election. Even (Taiwan OTC: 6436.TWO - news) though Renzi has said he will resign, a new government is likely to be formed and that will lead to a bit more stability," said Seamus Mac Gorain, portfolio manager at JPMorgan Asset Management.

The gap (Frankfurt: 863533 - news) between Italian and German yields widened to around 170 bps from around 163 bps on Friday. But the spread held below recent 2 1/2-year peaks over 190 bps, a sign that the selling in Italian bonds was contained.

The scale of the swing against Italy, before a vote that had no clear outcome, put some investors off trading it altogether.

"We were of the view that the referendum itself was not a significant market event. It was built up in the Anglo-Saxon press as a vote on the euro and future of Italy's membership - but it was not," said Peter Fitzgerald, who heads Aviva (Amsterdam: AW8.AS - news) Investors' global multi-asset investment team.

Others remain wary of taking positions on Italian banks like Monte dei Paschi with so much uncertainty over their future.

"The failure of the referendum makes a successful recapitalisation of Monte dei Paschi even less likely. However, it may perversely be a catalyst for something of a fudge to occur, if political uncertainty is used as an excuse to underwrite the issue using public money," said Mark Dowding, co-head of investment grade debt at BlueBay Asset Management. (Additional reporting by John Geddie; Editing by Larry King and Gareth Jones)