* S&P affirms Italy rating at BBB, lifts outlook to stable
* Italy's two-year yield falls to one-year low
* Move reduces risk of other agencies downgrading Italy to junk
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Adds details, charts, updates prices)
By Abhinav Ramnarayan and Yoruk Bahceli
LONDON, Oct 26 (Reuters) - Italian government borrowing costs dropped across the curve on Monday, with short-dated bond yields hitting a one-year low, following ratings agency S&P Global's unexpected upgrade of the country's ratings outlook to stable from negative.
The revision late on Friday of Italy's sovereign outlook offered some unexpected good news for the euro zone's third-largest economy and cements its long-term credit rating at BBB for the foreseeable future.
Investors were worried about the possibility of a near-term downgrade to BBB- from S&P, which has it on a higher credit rating than Moody's or Fitch Ratings. A downgrade from S&P would have put the country's credit rating from all three main rating agencies one notch above junk.
"The S&P move reduces near-term risks of Italy falling below investment grade that would have had implications on BTP holdings by real money accounts and market pricing," said Annalisa Piazza, an analyst at investment manager MFS.
A downgrade to junk territory would toss Italy out of bond indices that many funds track, forcing managers to sell their holdings.
Piazza added that such a downgrade would have made it difficult for the European Central Bank to keep financing conditions under control.
On Monday, the first day of trading after the decision, Italy's benchmark 10-year yields fell as much as 9 basis points to a one-week low of 0.674%. They were last down 3 basis points at 0.73%.
Short-dated two-year Italian yields hit their lowest level in a year at -0.382%.
The yield on Italy's inflation-linked bond due 2028, the 10-year inflation-linked benchmark quoted by Refinitiv, briefly fell into negative territory as low as -0.034%. But nominal bond yields adjusted for current inflation remain positive.
The ratings boost is predicated on the unprecedented stimulus measures the European Union and the ECB have taken to boost euro zone economies during the COVID-19 pandemic.
It comes as Rome introduced fresh restrictions to try to halt coronavirus infections that have reached record highs.
Later this week, investors will be looking for clues on a potential further monetary policy boost when the ECB's governing council meets on Thursday.
They will also watch euro zone gross domestic product numbers, inflation and unemployment data.
On Monday, Germany's Ifo institute's business climate survey showed that business sentiment in the bloc's biggest economy is being undermined by rising COVID-19 infections.
(Reporting by Abhinav Ramnarayan and Yoruk Bahceli, editing by Larry King and Emelia Sithole-Matarise)