Italian yields retraced a sharp move higher on Monday as the threat of a rebellion against Silvio Berlusconi from within his own party offered hope that Italy might avoid an early election.
As many as 20 senators from Berlusconi's centre-right party are ready to form a breakaway group unless the former premier backs down on his hard line to bring down Italy's government, a top member of the party told Reuters on Monday.
That may give Italian Prime Minister Enrico Letta a chance to save his government after five PDL ministers resigned on Saturday.
"As is often the case in Italian politics, this beast reinvents itself and so it becomes less threatening, that's exactly what we've seen," David Keeble, global head of fixed income strategy at Credit Agricole said.
"We have got Letta now with the possibility of limping along for another six months, which is never a great situation but if he can not have to rely on Berlusconi, this coalition might actually look more stable."
Ten-year Italian bonds last yielded 4.57% having risen as far as 4.75% earlier in the day, according to Tradeweb data.
The gap over benchmark German Bund yields rose to the widest since end-June at just above 300 bps earlier, but was last at 285 bps.
According to data monitor Markit, the cost of insuring Italian debt against default via five-year credit default swaps was last 3 basis points higher on the day at 267 bps having risen to 280 bps earlier - the highest since early July.
"It's not clear that there will be new elections, there is dissent from Berlusconi's party, so it's possible that the government might well survive," one trader said.
Spanish and Irish 10-year bonds, which have often fallen victim to Italian political ructions during the euro zone debt crisis, proved resilient to the volatility in Italian markets on Monday.
Analysts said Italian yields would have to get closer to their crisis peaks of over 7% before its political risks spilled over, but they did not expect such a move.
After the February vote, yields did not sustain a break above 5%. "It's very difficult to be short Italy because it carries so nicely," said Keeble, referring to the pick-up it offers over some of its euro zone peers.
"I think you can't scare people out for long." Governments and policymakers are also better positioned to deal with renewed tensions.
Italy and Spain have already completed more than 80% of their funding plan for this year and domestic investors, who tend to hold assets for longer than foreign investors do, hold two-thirds of the tradeable debt in both markets.
Also, the European Central Bank's conditional promise to buy government bonds, so far untested, still has a prophylactic effect on crisis flare-ups.
"It's not as black or white as it was at the beginning of the crisis. Investors differentiate much more," DZ Bank strategist Christian Lenk said.
German Bund futures rose to their highest in a month to 140.87 but settled only 5 ticks higher at 140.50. The threat of a US government shutdown was having little impact on German bond markets.
The Republican-controlled House of Representatives passed a measure on Sunday that ties government funding to a one-year delay of President Barack Obama's landmark healthcare law, while Senate Democrats have vowed to reject it.
If a stop-gap spending bill for the new fiscal year is not passed before midnight on Monday, government agencies and programs deemed non-essential will begin closing their doors for the first time in 17 years.
"The risk (of a government shutdown) is more elevated ... but we're still confident there will be a compromise," BNP Paribas rate strategist Patrick Jacq said.