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(Corrects date of Portugal's draft budget in paragraph 2)
* Portugal cuts deficit target for 2017
* German paper reports possible establishment of Portugal bad bank
* Spanish and Italian yields also dip
By Abhinav Ramnarayan
LONDON, Oct 18 (Reuters) - Portugal's government bond yields hit one-month lows on Tuesday ahead of a crucial ratings review from DBRS this week.
Portugal on Friday slashed its deficit target for 2017 to 1.6 percent of economic output from this year's estimated 2.4 percent, and a report overnight from German newspaper Handelsblatt suggested the government is planning to set up a bad bank to deal with the struggling banking sector.
Those two developments strengthened expectations that DBRS would leave the country's last investment grade rating untouched at a scheduled review this Friday.
Concerns over the rating - with eligibility for the European Central Bank's asset purchase programme in the balance - has weighed on Portugal's government bonds since mid-August.
"I think the market now believes the investment grade rating should survive, and we tend to that view as well," said Commerzbank rates strategist David Schnautz. "It remains to be seen if this is just a feel good environment or if it is justified."
He sounded a note of caution, saying that it remains to be seen if the deficit target - part of the draft budget proposal for 2017 - proves feasible.
Portugal's 10-year bond yields rose from an Aug. 15 low of 2.69 percent all the way up to 3.63 percent last Monday, October 10. Since then, government comments suggesting the rating was safe and further good news have pushed yields lower.
On Tuesday, the yield on the Portugal 10-year benchmark fell 1.5 basis points to 3.25 percent by 0700 GMT, before rising again.
One of DRBS's key concerns have been around the Portuguese banking sector, and the government is planning to create a bad banks to absorb its bank's non-performing loans (NPLs), Handelsblatt reported on Monday.
"This is a reminder that there are issues for Portugal beyond Friday's review, and NPLs are a very difficult beast to tackle," said Schnautz. "Though the mechanics of the bad bank are still unclear, at the very least they are dealing with issue head on."
The yield on other southern European government bonds also fell on Tuesday, with Spain's 10-year bond yields dropping 1.3 bps to 1.11 percent and Italy's 10-year dropping 1.2 bps to 1.39 percent .
Higher-rated euro zone government bonds were more or less flat on the day, following Monday's sharply volatile session.
For Reuters new Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets (Reporting by Abhinav Ramnarayan; Editing by Alison Williams)