Italy's borrowing costs fell from recent record highs at a bond auction on Thursday but cautious investors still demanded a near 7 percent yield to buy 10-year debt, a level seen unsustainable over time for the euro zone's third-largest economy.

Traders said the European Central Bank stepped in after the auction to buy Italian bonds on the open market as investors worry about the country's ability to sell enough long-term debt ahead of large redemptions early next year.

The ECB's injection of nearly half a trillion euros of cheap funding for banks and a new Italian budget package this month have eased pressure on short-term debt, but longer-dated bonds still pose a challenge.

Italy raised 7 billion euros ($9 billion) of debt in thin holiday markets, just above the mid-point of its target range.

It sold the top planned amount of its 10-year benchmark bond but the yield was 6.98 percent, not far from a euro lifetime record of 7.56 percent a month ago.

The yield on the three-year BTP bond fell more markedly to 5.62 percent from a euro era record of 7.89 percent at an end-November auction. At the time, in a sign of acute market worries about Italy's ability to repay, the three-year yield was higher than the one on the longer maturity.

Today's decline in the auction yield by 'just' about 60 basis points versus end-November in such a high-yield territory underscores that the genuine pressure on Italy is still tremendous, despite bold ECB actions that have given (short-term

debt) a big boost, said David Schnautz, a rate strategist at Commerzbank in London.

The fall in the three-year yield came after Italian six-month borrowing costs halved at an auction on Wednesday.

These were the first Italian debt sales since the ECB flooded euro zone banks with three-year funds and the Rome government overcame internal opposition to a radical pension reform as part of Italy's third budget package since the summer.

This week's auctions will settle in January and help towards

the Treasury's challenging gross funding target of around 450 billion euros has for next year.

In a push to keep investors buying Italian debt, a new technocrat government in Rome is planning to tackle Italy's chronic low-growth problems.

But markets look with concern at some 91 billion euros of Italian bonds coming due between January and April.

Given the scale of its funding requirements, there are still big concerns about Italy's ability to get through 2012, said Nicholas Spiro of Spiro Sovereign Strategy. Next quarter is going to be all about Italy.

While Italy can count on strong domestic support such as from retail investors at its short-term debt sales, its longer-dated bonds are more reliant on foreign buyers, giving a clearer picture of the market attitude towards the country's debt.

The ECB intervened after the sale as Italian 10-year yields remained locked above 7 percent on the secondary market. ($1 = 0.7724 euros)

(Additional reporting by London and Milan bonds team; Editing by Ruth Pitchford)

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