* Italian yields fall to lowest in nearly 2 years
* Solid demand at sale of five-, ten-year Italian debt
* Spanish yields hit lowest since March
* After Greek deal, improved periphery sentiment continues
LONDON, Nov 29 (Reuters) - Italian borrowing costs hovered near their lowest in nearly two years on Thursday as appetite for higher-yielding euro zone debt persisted and benefited an auction of five and ten-year paper.
Appetite at the Italian auction was buoyed by a further improvement in sentiment towards riskier debt after a deal on the next tranche of Greek aid this week was seen as reducing the systemic risk in the region.
Italy's borrowing costs over ten years hit their lowest in two years at the auction as investors snapped up 5.98 billion euros of five- and ten- year debt, resulting in a 1.18 bid-to-cover which was below the previous three sales' average.
"The pricing side looks quite healthy which is very significant given that we not only saw a rally yesterday but also this morning into the auction," Michael Leister, strategist at Commerzbank said. "Clearly demand is very strong, you could almost say flamboyant."
Italian and Spanish debt have benefited in recent months from the European Central Bank's pledge to buy sovereign debt if countries ask for aid first. Even though that has not happened yet, the prospect of a central bank backstop has made investors reluctant to sell and has pushed them back into those markets.
In the secondary market, ten-year Italian yields were down 6.8 basis points at 4.52 percent, having reached lows of 4.49 percent before the auction.
Five-year Italian yields fell 2.8 bps to 3.25 percent, having reached as low as 3.17 percent earlier.
"The way they are going out of their way to find a solution ... if they are willing to do that for Greece then that gives some support to the other peripherals," Elisabeth Afseth, fixed income analyst, at Investec said.
"That (explains) much of (the move) and there is clearly still quite a substantial yield pick-up."
Spain's borrowing costs over ten years hit their lowest since March at 5.21 percent. They were last down 7 basis points at 5.27 percent.
"Looking out over the medium-term we would expect 10-year Spain to remain trapped within (the) 6.15 and 5.26 (range) with the bias probably to sell Spain on any drop in yields down to trendline support again at 5.26 percent," Credit Suisse technical analysts said.
U.S. FISCAL LIMBO
U.S. House of Representatives Speaker John Boehner said on Wednesday he was "optimistic" on reaching a budget deal before the end of the year to avoid a crisis, underpinning global equities overnight.
Signals from lawmakers, however, have been mixed, and markets were expected to remain sensitive to any comments on the progress of talks in the United States to avert $600 billion worth of automatic tax hikes and budget cuts next year.
"It's the biggest single factor between now and the end of the year in terms of moving the market. Bond markets are pretty thin and (the danger is) we react to every headline/soundbite," a trader said.
For now, German bonds were taking their cue from higher equity markets, and Bund futures fell 23 ticks on the day to 142.71.
But there was still some upside until the contract met technical resistance, some said.
Credit Suisse technical analysts said they saw a resistance zone for the December Bund future between 143.48 - the November high and 143.65 - the 61.8 percent retracement from the highs in May-June.