* 10-yr bond yields at highest since Oct. 2012 at auction
* Italy draws solid demand at sale, market relieved
* Political parties trying struggling to form a government after vote
By Francesca Landini
MILAN, Feb 27 (Reuters) - Italy's borrowing costs rose to their highest in four months on Wednesday at the first bond auction since this week's inconclusive election but solid demand from domestic investors eased fears that the political deadlock could destabilize Europe's second-biggest sovereign debt market.
The level of demand brought some relief to the market after the extreme volatility seen immediately after an election in which no party won enough seats to govern.
In a signal of political difficulties to come, comedian and populist leader Beppe Grillo, who holds the balance of power, ruled out voting for any government led by the traditional parties but said his 5-Star Movement could back individual laws.
The Treasury sold the maximum planned amount of 4 billion euros of the new 10-year bond but the yield it had to offer jumped to 4.83 percent, the highest since October but still well short of levels of more than 6 percent seen in June.
"They got it done. The yields are higher than anything they've done for quite some time but that's hardly a big surprise," said Elisabeth Afseth, a rate strategist at Investec.
Yields in the secondary market were, however, a little easier than on Tuesday, when financial markets across the globe fell sharply after an election which left no party with enough support to form a parliamentary majority.
There were signs that foreign investors stayed away from the auction because of the political uncertainty, leaving Italian institutions to buy up most of the paper.
"Demand for both lines was relatively solid, probably led by domestic accounts which took advantage of higher yields," wrote Newedge strategist Annalisa Piazza.
"It's clear that foreign accounts played no major role at today's auction as the political risk remains high."
The bid-to-cover ratio was a healthy 1.65 - bids totalled 6.6 billion euros - and Italian debt prices and European stocks briefly rose on Wednesday after the results, with investors relieved that the sale had gone smoothly.
Rome's 10-year yields in the secondary market fell 7 basis points to 4.83 percent having reached almost five percent in the morning ahead of the sale.
Even at this level, however was well down on the 6.19 percent in June, before the European Central Bank's pledge to buy government bonds of weaker euro zone countries, which defused the euro zone debt crisis at the time.
Italy also issued 2.5 billion euros of a five-year bond on Wednesday, paying a yield of 3.59 percent, up from 2.94 percent one month ago.
An auction of six-month bills on Tuesday also saw yields on short-term debt rise sharply compared with the previous sale.
The Italian Treasury had taken advantage of a benign market environment at the beginning of this year to cover more than 20 percent of its total 2013 refunding needs estimated at 420 billion euros.
In the case of a protracted political stalemate, however, Italian banks would have to continue absorb the largest part of the country's debt, with foreign investors sitting on the fence.
The dramatic surge of Grillo's anti-establishment 5-Star Movement dominated an election which left the centre-left bloc with a majority in the lower house but without the numbers to control the upper chamber.
That left the parties to try to build an alliance between forces that have so far shared nothing but deep mutual hostility. The alternative is an early return to the polls.
Pier Luigi Bersani, head of the centre-left Democratic Party (PD), has the difficult task of trying to agree a "grand coalition" with conservative former premier Silvio Berlusconi, the man he blames for ruining Italy, or striking a deal with Grillo, a completely unknown quantity in conventional politics.
On Wednesday, Grillo said 5-Star would support individual measures in parliament on merit but would not give a confidence vote to any government led by traditional parties.
Moody's Investors Service said the outcome of the vote could be bad for Italy's credit rating because it raises the possibility of new elections.
Standard & Poor's said policy choices by the next government would be crucial for Italy's creditworthiness, underlining the need for a coalition that can agree on new reforms to improve the country's growth outlook.
The technocrat government headed by Mario Monti pulled Italy from the brink of a Greek-style financial collapse in November 2011 and triggered a gradual decline in its borrowing costs.
Monti, however, struggled to pass the kind of structural reforms needed to improve competitiveness and lay the foundations for a return to growth.
The country has been stuck in recession since mid 2011 after recording average growth of less than 0.3 percent between 2000 and 2010, the third lowest in the world, ahead of only Zimbabwe, Eritrea and Haiti.