Euro zone debt rallies as ECB eases collateral rules, Fed
* Portuguese government seen surviving no confidence vote
* Other euro zone bonds firmer with Fed seen flexible on QE
* Spanish bond auction finds solid demand
By Marius Zaharia and Emelia Sithole-Matarise
LONDON, July 18 (Reuters) - Euro zone debt firmed across the board on Thursday after the European Central Bank eased its collateral rules and as the U.S. Federal Reserve's flexible approach to reducing its bond purchases soothed investor nerves.
The ECB said it was expanding the list of asset-backed securities that are eligible for use by banks in exchange for its cheap loans and reducing the discount it applies to these assets.
Yields on debt issued by Italy and Spain, whose banks are seen benefiting most from the ECB move, extended falls. Italian yields fell 8 basis points 4.42 percent with the Spanish equivalents down by a similar amount at 4.62 percent.
"The market is taking it positively... because the ECB has been looking to do something and now has finally moved, but in essence it's not a great change," said RBS strategist Michael Michaelides.
"It is rather trying to help the SME (small and medium enterprises) financing as opposed to releasing more cash into the system."
The firmer tone in peripheral bonds was helped by a successful Spanish bond sale as investors shrugged off a political scandal surrounding Prime Minister Mariano Rajoy.
Demand as indicated by bid/cover ratios looked strong, even accounting for the smaller-than-usual amount on offer, analysts said. Borrowing costs fell as well.
The auction is a sign the policy outlook of central banks around the world remains supportive for high-yielding debt.
Testifying to U.S. lawmakers on Wednesday, Fed Chairman Ben Bernanke left the door open to changing plans to reduce monetary stimulus if the economy requires.
The ECB said earlier in July it will keep interest rates at record lows for an extended period, and could also activate its bond-buying programme if tensions rise. The ECB's year-old commitment to do "whatever it takes" to preserve the euro and its subsequent bond-buying pledge helped stabilise the crisis-hit currency zone.
"The market, including Bunds, is generally bullish following Bernanke's testimony. Fears of tapering are even further in the background. We've seen some Spanish domestic accounts buying after the auction but volumes remain light," a trader said.
German Bund futures hit six-week highs of 144.35, up 41 ticks on the day before retreating slightly to settle at 144.23. Ten-year cash yields fell 2 bps to 1.52 percent.
Portuguese bonds extended the previous day's gains with political parties seen closer to a pact to keep the country's aid programme on track.
In what market participants interpreted as a sign they might have found common ground, the parties said on Wednesday they could hold an extraordinary parliamentary session on July 29 to discuss any agreement they come to.
Ten-year Portuguese bond yields fell 20 basis points to 7.11 percent, still above levels viewed by market participants as unsustainable in the long-term, while five-year yields dropped 26 bps to 6.8 percent.
"The market is looking at a grand salvation coalition agreement as a positive scenario," said Gianluca Ziglio, executive director of fixed income research at Sunrise Brokers.
"It might be naive though ... If the agreement becomes effective it is not necessarily automatic that Portugal will be able to come back to the market."