* Spain's 3-year, 5-year bond yields down from July 18 sale
* Treasury sells more debt that expected
* Yield fall comes as PM testifies on corruption
* 'No one's really paying attention' to scandal, says strategist
By Paul Day
MADRID, Aug 1 (Reuters) - Spain sold more bonds than expected at falling yields at an auction on Thursday, as investors brushed off a graft scandal the prime minister said had damaged the country's standing abroad.
The Treasury sold 3.2 billion euros ($4.3 billion) of bonds due in 2016 and 2018 compared to a target range of between 2 billion and 3 billion euros.
Yields dropped on both maturities from two weeks ago, with the longer paper raising 2.3 billion euros at 3.561 percent compared with 3.735 percent. The Treasury has now sold 76 percent of its end-of-year medium- and long-term target amount of debt.
The sale took place as premier Mariano Rajoy told parliament he made a mistake in his handling of the slush fund scandal, in which he and his ruling centre-right People's Party have been implicated, but he denied he or other party leaders had received illegal payments.
"There was some market concern about a month ago that Rajoy was going to be forced to resign but since then he's said he would carry out the full term, so no one's really paying attention to it," said Bhavisha Patel, a strategist at consultancy 4Cast.
Spain last sold the same paper on July 18, at a time when investors were fretting about a political crisis in neighbouring Portugal and the potential knock-on effect of the U.S. Federal Reserve withdrawing is monetary stimulus programme.
Although the political picture in Spain has turned murkier since, Thursday's auction was supported by a run of relatively positive economic data, both domestic and from the wider euro zone.
Overnight comments by the Fed that the U.S. economy continued to need support and expectations that the European Central Bank will reiterate its commitment to record low interest rates later on Thursday have also boosted sentiment for riskier assets such as peripheral euro zone debt.
The sale was also supported by a large Spanish redemption earlier this week which added liquidity to the market, Patel said.
Spanish debt costs soared to record levels last year before the ECB pledged to do what was necessary to protect the euro.
Since then, the yields the Treasury must pay to bond holders have fallen despite a deep recession and, latterly, the graft scandal that has undermined domestic voters' faith in Rajoy's party.
Further evidence that investors are paying little heed to underlying political or economic realities came with Thursday's Purchasing Managers' Index (PMI) survey, which showed Spanish manufacturing activity shrank again in July after holding steady in June.
That suggested the economic recovery may still be some way off, puncturing some of the optimism generated by data earlier in the week showing the first drop in unemployment in two years and an economy that all but stabilised in the second quarter.
Spain's economy has been shrinking since mid-2011.