* Merkel won't seek re-election as party head- source
* German bond yields rise, underperform EZ peers
* Italian yields fall to almost one-month lows
* S&P leaves Italy's ratings unchanged, lowers outlook (Updates prices)
By Dhara Ranasinghe
LONDON, Oct 29 (Reuters) - German bond yields rose on Monday after Chancellor Angela Merkel said she would not seek re-election as party chairwoman and that her fourth term as chancellor would be her last, while Italian yields fell on relief at an unchanged ratings verdict from S&P.
Merkel has been chairwoman of her conservative Christian Democrats (CDU) since 2000 and chancellor since 2005. Her decision to step down as chairwoman comes after her party suffered its second regional election setback in as many weeks.
The move also sets in motion the process for the CDU to settle on, and groom, Merkel's successor.
While German bonds, regarded as one of the safest assets in the world, often benefit from uncertainty, the implications of latest political developments left even German bond investors slightly rattled while the euro weakened.
"This news would signal the quality of German credit would deteriorate because markets are extrapolating from the results of the weekend state election to conclude that the next government will have a bigger populist portion to it," said Mizuho rates strategist Peter Chatwell.
"So that explains the rise in German yields but there is also a need to treat German bonds as a risk-free (investment), so if there was a lot of stress a selloff would be limited."
Germany's benchmark 10-year Bund yield rose three basis points to 0.38 percent, above seven-week lows hit last week at around 0.34 percent.
Across the German curve, yields were up 2-5 bps on the day.
The risk of the German coalition collapsing before the next election had risen, analysts said.
"Perhaps the biggest implications are for the euro zone as a whole," said Jennifer McKeown, chief European economist at Capital Economics. "Given her (Merkel's) weakened position, an agreement over Italy's budget may take longer to reach, increasing the threat of contagion to other markets and adding to the risks to Italian banks."
For now, Italian bonds took their steer from news on Friday that ratings agency Standard & Poor's had decided to leave Italy's rating unchanged at BBB, two notches above junk.
S&P lowered the ratings outlook to negative from stable, saying that the new government's policy plans were weighing on the country's growth and debt prospects.
But the decision to leave the rating unchanged, a week after Moody's downgraded its Italy rating, bought some relief.
Italy's 10-year bond yield fell to its lowest in almost a month at 3.29 percent, before settling at around 3.32 percent by the close.
The gap over top-rated German bond yields narrowed to 294 bps from around 306 bps late Friday.
"The underlying budget concern is an ongoing issue but the ratings risks are out of the way for the rest of the year as there are no more scheduled ratings decisions," said Commerzbank rates strategist Rainer Guntermann.
Lower Italian yields dragged Spanish and Portuguese yields down , but the selloff in German bonds and a firmer tone in European stock markets pushed up yields on higher-rated euro zone bonds .
Reporting by Dhara Ranasinghe, editing by Richard Balmforth, William Maclean