* Spanish yields extend falls after 10-year bond sale
* Portugal sells 5-year bond; demand strong
* Sale is Portugal's return to bond market post 2011 bailout
* Bunds edge up but recovery seen fragile
By Emelia Sithole-Matarise
LONDON, Jan 23 Portuguese debt yields fell on Wednesday with investors heartened by strong demand at a five-year debt sale marking the country's first foray into bond markets since its 2011 bailout.
Investor bids for Portugal's reopening of its October 2017 bond were last around 8 billion euros, four times more than the 2 billion euros the Treasury was aiming to place, prompting it to lower its price guidance.
It followed Spain's launch of a new 10-year benchmark bond on Tuesday that drew unprecedented demand and recent successful Italian auctions from Italy, setting the euro zone stragglers' 2013 fund raising efforts off to a solid start, thanks to renewed investor appetite for their debt.
Portuguese five-year yields were last 6 basis points down on the day at 4.89 percent, having broken on Tuesday below 5 percent for the first time in two years, with 10-year bond yields down 5 bps on the day at 5.80 percent.
Ten-year yields have tumbled from around 18 percent hit early last year to trade just 80 bps above higher-rated Spain, as investors warmed to Libson's progress on fiscal reforms and stabilising peripheral markets in the last half of 2012 after the European Central Bank unveiled a new bond purchase scheme.
Further declines in Portuguese yields were expected once the bond sale was out of the way, though some strategists voiced caution at the pace of the rally given Portugal's relatively small market.
"There's a wash of money out there and people are hunting for yield and it's difficult to fight it. Portugal is benefiting from the general risk-on tone over the last couple of months," said Lyn Graham-Taylor, a strategist at Rabobank.
"It's been a very impressive performance but it's a small market now. You're getting a convergence of spreads because of the liquidity not because there's been further steps towards a systemic solution of the crisis or because countries are suddenly returning to growth or got better fundamentals."
COURTING THE ECB
Some in the market said the choice by Portugal to tap the 2017 bond appeared to be aimed at getting Lisbon closer to qualifying for the European Central Bank's programme of bond purchases, known as Outright Monetary Transactions, or OMT. The programme is only available to countries that have normal access for long-term bonds.
"Portugal is some way away from getting full market access so the OMT is not on the horizon just yet but it's a step in the right direction," RIA Capital Markets strategist Nick Stamenkovic said.
"But the fact that Portugal is looking to raise money at this juncture clearly shows the authorities have noticed sufficient investor support out there and are taking advantage of conditions."
Basking in the afterglow of Tuesday's successful 10-year debt sale, Spanish bonds of that maturity yielded 5.10 percent , down 5 bps on the day with Italian equivalents slightly lower.
"There seems to be a lot of interest and hunt for yield so it's difficult to call an end to the rally in periphery," another trader said.
The rally in the euro zone's periphery cooled demand for low-risk German Bunds, which reversed earlier gains. Bund futures were last unchanged on the day at 143.12 with German 10-year yields holding steady at 1.52 percent.