Portugal yields fall to 3-1/2-yr lows before ratings decision
* Portuguese yields close to piercing below 5 pct
* Hopes S&P will upgrade ratings outlook fuel demand
* Spanish yields fall after above-target debt sale
* Economic outlook, bond repayments supporting demand
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Jan 16 (Reuters) - Portuguese yields slid to 3-1/2-year lows on Thursday as expectations Standard & Poor's will raise the country's credit ratings outlook and open to the door to a resumption of bond auctions fuelled investor demand.
Junk-rated Portuguese bonds outpaced many of their euro zone peers, including in Spain where investors snapped up 5.9 billion euros of debt earlier on Thursday - above the 5.5 billion euros Madrid was targeting at its second auction of 2014.
Improving global growth and signs that the cycle of ratings downgrades for the euro zone's weaker economies may be over is spurring a rally in higher-yielding bonds.
Investors anticipate a positive review of Portugal's credit outlook on Friday when S&P is due to make its assessment under a new EU-regulated schedule. Moody's is also scheduled to decide on Ireland which it currently rates sub-investment grade.
The European Union rules that came into force this month make credit agencies operating in Europe say when they will review a country's ratings.
S&P has said it will definitely release a statement on all scheduled dates, unlike Moody's, which last Friday refrained from releasing a statement on Portugal, saying it was not obliged to if it made no change to its stance.
Last Friday, S&P affirmed Germany's AAA rating with a stable outlook. Portugal's BB rating is on credit watch negative.
"Over the past six months financing conditions have improved considerably and the political climate has stabilised," said Philip Shaw, chief economist at Investec. "It might be early days to be talking about an upgrade, but leaving it on credit watch negative would be very harsh."
Portuguese 10-year yields dropped as much as 14 basis points to 5.07 percent, taking them to mid-2010 lows before Lisbon was sucked into the euro zone debt crisis which led it to seek international aid in 2011.
Towards the end of the trading session, yields rebounded to 5.16 percent. Traders citing profit-taking as investors became cautious before the ratings decision.
Lisbon is aiming to follow Ireland and leave it rescue package later this year as its economy recovers from its worst recession since the 1970s. It said on Wednesday it expects to resume bond auctions in the first half of 2014.
Spanish yields dipped 3 bps to 3.74 percent, inching towards five-year lows just below 3.70 percent hit last week after Madrid sold more debt than planned.
Madrid is setting a brisk pace for its 2014 funding programme and the sale of 2017, 2026 and 2028 bonds comes a week after Madrid raised an above-target 5.3 billion euros at an auction of 5- and 15-year bonds.
The glut of bond supply has tempered a sharp rally in peripheral debt but not reversed it, which analysts said showed the strength of the hunt for yield. Euro zone borrowers are also benefiting from more than 50 billion euros in debt repayments hitting the market this week.
"We are starting to see a revival of demand from Spanish banks and that's a difference from what we've seen in the last months of 2013 when they were selling some of their debt. There's also demand from non-domestic investors. That should support the rally for Spanish bonds," said ING strategist Alessandro Giansanti.
German 10-year yields were 5 bps down at 1.78 percent, benefiting mainly from debt repayments, traders said.
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