CORRECTED-Portuguese yields dip as Lisbon works to defuse political crisis
(Corrects paragraph 3 to clarify parties seeking deal on austerity policies)
* Investors remain nervous before June 21 talks deadline
* Spanish debt market shrug off growing political tensions
* Rest of market steady as Bernanke testimony eyed
By Emelia Sithole-Matarise
LONDON, July 16 (Reuters) - Portuguese bond yields dipped on Tuesday as the bailed-out country's political parties agreed talks to end a crisis, though investors doubted a deal would be reached soon.
Portuguese bonds found a firmer footing in a stable euro zone debt market with Prime Minister Pedro Passos Coelho expected to survive a vote of no confidence due on Thursday called by the smaller Green Party.
Questions remained over whether Coelho and Socialist Party leader Antonio Jose Seguro can reach a deal by a July 21 deadline on painful austerity policies linked to the country's international bailout.
Five-year yields fell 10 basis points to 7.17 percent while 10-year yields eased 4 bps to 7.35 percent, retreating from highs near 8 percent hit last week after Lisbon delayed a review of its bailout due to the crisis.
Although five-year bonds have recouped some of last week's losses, the 5/10-year yield gap remained near its narrowest since June 2012, reflecting elevated credit risk.
When investors see risks a country may not fully repay its debt, they quote its bonds by price instead of yield as they are more concerned about what they can recover than their return. Portuguese 10-year bonds traded at some 83 cents in the euro.
"They have done a reasonable job on the austerity programme but ... this political uncertainty doesn't help and it remains to be seen on how flexible the Socialist Party is going to be on austerity," said Lyn Graham-Taylor, a strategist at Rabobank.
"The market remains nervous and the reason why the curve has aggressively flattened at the front end is that people are getting concerned that some kind of haircut may be required before they can get back to the market. I still think we are a long way from that possibility being discussed."
RESILIENT SPANISH BONDS
Euro zone debt investors were wary of putting on big positions before U.S. Federal Reserve Chairman Ben Bernanke's semi-annual congressional testimony on Wednesday and Thursday on the future of the central bank's massive bond purchases.
The Spanish market shrugged off mounting pressure on Prime Minister Mariano Rajoy to resign over a party financing scandal. Rajoy on Monday rejected opposition calls for him to quit and said his reform plans would not be held back.
Spanish 10-year yields were up 2 bps at 4.71 percent while equivalent Italian yields were up by a similar amount at 4.48 percent.
RBC strategists, however, urged caution against extending exposure to Spanish bonds beyond shorter-dated maturities that fall within the scope of the European Central Bank bond buying scheme that has eased the debt crisis over the past year. (Editing by Nigel Stephenson)
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