* Benchmark yields end above 3 percent near 2-1/2-year high * U.S. 10-year yield rises 1 percentage point in 2013 * Treasuries set for 3rd-worst year in 40 years - Barclays * U.S. bond market sets for 2nd-biggest annual loss in 40 years By Richard Leong NEW YORK, Dec 31 (Reuters) - Benchmark U.S. Treasury yields rose to their highest in nearly 2-1/2 years on Tuesday, capping the third-worst year for the government debt market in four decades as investors trimmed bond holdings ahead of the Federal Reserve reducing its bond-purchase stimulus in 2014. The dismal year for Treasuries was a drag on the entire U.S. bond market, which will book its second-biggest annual loss since the mid-1970s. "U.S. bond market performance in 2013 was all about the Fed," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia. In a light, shortened session, benchmark 10-year note yields rose five basis points to 3.026 percent, just below the near 2-1/2-year high of 3.036 percent set just before the market closed. The U.S. bond market closed early at 2 p.m. EST (1900 GMT) and will stay shut on Wednesday for New Year's Day. For the year, the 10-year yield rose 1.27 percentage points, according to Reuters data. Yields on medium-to long-dated maturities jumped at least 1 point in 2013, while the two-year yield grew only 13 basis points as the Fed signaled it would hold short-term rates near zero for a protracted period even after it stops buying bonds to keep interest rates low and stimulate the economy. Treasuries remain on shaky ground as yields are expected to rise further in the coming months, albeit at a slower pace than the one seen this year in reaction to when Fed Chairman Ben Bernanke introduced in late May the notion the U.S. central bank might shrink its third round of quantitative easing, or QE3, by the end of the year. The possibility of a policy shift roiled the bond market this summer, causing the 10-year yield to spike to its highest in more than two years by early September. Treasuries yields retreated later that month when the Fed surprised the market by not tapering bond purchases, but they resumed their climb this month when it opted for a modest reduction in its monthly purchases of Treasuries and mortgage-backed securities. On Dec. 18, Fed policy-makers said they will pare QE3 purchases by $10 billion a month to $75 billion in January. How quickly the Fed dials back QE3 will depend on improvement in the labor market and whether inflation picks up and moves closer to its 2 percent target next year. "Inflation and economic growth will be more significant for 10-year and longer bond yields in 2014, and we're expecting those yields will drift modestly higher," LeBas said. U.S. YIELDS SEEN RISING FURTHER In a Reuters poll released Dec. 11 before the Fed's tapering decision, the median forecast among analysts on the U.S. 10-year yield at the end of 12 months was 3.35 percent. Such a modest rise in yields will only nick Treasuries further, not bludgeon them as seen in the past seven months. "At the end of the day, we are to see flat to slightly negative (returns) in 2014," Jennifer Vail, head of fixed-income research at U.S. Bank Wealth Management in Portland, Oregon, said of Treasuries. Year-to-date, U.S. Treasuries posted a 2.63 percent loss through Monday, the third-steepest decline behind a 3.57 percent decline seen in 2009 which was their worst annual drop, according to an index compiled by Barclays. The sell-off in government bonds was most intense among long-dated issues, which the Fed targeted for its QE3 purchases. They have lost 13.93 percent this year, exceeded only by the whopping 21.4 percent plunge in 2009, Barclays data showed. The third-worst year for Treasuries in 40 years rippled across the bond market. The Barclays U.S. Aggregate Index, which measures the performance of Treasuries, mortgage securities, corporate bonds and other investment-grade debt, was down 1.92 percent year-to-date. It was the second-biggest annual decline ever in the index's history going back to 1976. This year's loss was surpassed only by the 2.92 percent fall in 1994 when then Fed Chairman Alan Greenspan led a series of interest rate hikes. Bond volatility also spiked earlier in the year as the Fed hinted at an exit to QE3 stimulus, but as that tapering has come to pass, volatility has settled well below its mid-year levels. The Merrill Lynch three-month MOVE index, which estimates future volatility of long-term bond yields, ended 25 percent higher in 2013, its first annual rise since 2008. As bond yields rose and volatility grew this year, exchange-traded funds that bet against Treasuries enjoyed a banner year, not far behind the hefty gains on Wall Street. For example, the Proshares Ultrashort 20-plus Treasury ETF rose 25 percent, snapping a three-year losing streak. Meanwhile, the benchmark Standard & Poor's 500 stock index was poised to end the year up nearly 30 percent, which would be its biggest annual gain since 1997.