* Greece ends four-year exile from market borrowing
* Investors snapping up 3 billon euros of 5-year bonds
* Further sign that euro zone may be exiting debt crisis
* Greece sees sale as first step to end austerity, bailout
* Real economy remains bleak, politics toxic (Adds Greek prime minister, EU Commission vice president, Merkel protest ban)
By Sarka Halas and Karolina Tagaris
LONDON/ATHENS, April 10 (IFR/Reuters) - Two years after nearly crashing out of the euro zone, Greece returned to the bond market on Thursday with investors hungry for high returns scooping up its debt in a 3-billion euro deal that could mark the beginning of the end of its bailout.
Athens offered a yield of 4.95 percent to sell five-year bonds, the second lowest borrowing costs for a bailed-out euro zone state returning to the market.
The bonds, the first sold by the Greek government since the European Union and IMF rescued it four years ago, attracted more than 20 billion euros of interest from over 550 investors, including 1.3 billion from the banks which are lead managing the deal.
Greece - unlike its bailed-out euro zone peers Ireland and Portugal - defaulted on its debts as recently as 2012 and its credit rating remains deep in "junk" territory.
However, the bonds attracted investors because they offer a relatively high return in an era of ultra-low interest rates. Expectations that the European Central Bank will take further steps to boost the euro zone economy are also fuelling appetite for bonds issued by the bloc's riskier countries.
Greece's government said the sale marked the beginning of the end of the tough austerity linked to the 237-billion euro ($328 billion) bailout, which pushed unemployment to a record 27.7 percent and wiped out almost a quarter of the economy.
"Today, Greece took one more decisive step to exit the crisis," Prime Minister Antonis Samaras said in a televised address. "Confidence in our country was confirmed by the most objective judge - the markets."
Thursday's bond sale paved the way for the government and companies to undertake bigger and cheaper borrowings from international markets in the future.
Greece has defaulted a number of times in its modern history and its total debt is about 175 percent of its annual economic output, a level considered by economists as unaffordable in the long run. Investors, however, appear willing to overlook the fact that private bond holders suffered heavy losses when 130 billion euros of Greek debt was restructured two years ago .
"What this shows as much as anything is that capital markets participants have relatively short-term memories," said Jeremy Lawson, chief economist at Britain's Standard Life. "If things look like they are improving, then there will always be someone ready to lend to a given country - regardless of what the history of default may be."
Athens considers the sale as part of a gradual return to markets. It does not expect to cover all its funding needs from investors before 2016.
The country's creditors also welcomed the move, saying it vindicated the tough economic policies endured by the Greek people and would bolster sentiment throughout Europe.
"It is an important sign that the Greek economy is starting to regain the confidence of investors," said European Commission Vice President Siim Kallas, who is standing in as the EU's Economic and Monetary Affairs Commissioner.
But Kallas said Athens must stick to the path of budget reforms to strengthen its recovery. "It is crucial to continue ensuring rigorous delivery of the fiscal targets," he said.
Greece follows Ireland and Portugal in returning to the markets but its borrowing costs remain the highest in the euro zone. Still, the solid reception for the bonds buoyed sentiment and drove borrowing costs of other "peripheral" euro zone governments to the lowest level in a number of years.
Irish, Spanish and Italian 10-year bond yields were all 5 basis points down on the day at 2.90 percent, 3.16 and 3.15 percent A respectively.
An Irish sale of 1 billion euros of 10-year bonds also drew solid demand at a yield of 2.917 percent at its second regular auction since exiting its bailout in December.
Greece's debt currently stands at about 320 billion euros and it is rated nine notches below investment grade at Caa3 by the Moody's agency. Standard and Poor's and Fitch rank Greece six notches below investment grade at B-.
Deputy Prime Minister Evangelos Venizelos denied that the debt burden, which Greece aims to cut to 120 percent of GDP, is unaffordable. "The bond issue proves the debt is sustainable, otherwise the markets wouldn't have bought it," he said.
About 85 percent of Greece's debt is in the hands of the EU and International Monetary Fund, at very low interest rates and on a long repayment schedule. Private creditors hold about 30 billion euros of bonds with maturities between 10 and 30 years.
But a dawn explosion in a commercial district of Athens on Thursday showed how fragile the country's politics and society remain after six years of recession, its worst peace-time slump ever.
In the biggest bomb explosion the capital has seen in years, a booby-trapped car detonated on a street near a central bank building which houses the offices of the IMF's resident representative.
The blast happened a stone's throw away from the finance ministry, the privatisations agency and the headquarters of Piraeus Bank, the country's second-biggest lender.
No-one has yet claimed responsibility for the attack, which caused damage but no injuries and which police believe was carried out by leftist or anarchist guerrilla groups.
The explosion also came a day before a visit by German Chancellor Angela Merkel, whom many Greeks accuse of forcing painful cuts in return for the aid keeping it afloat.
Police have banned protests during her visit, but anti-bailout groups and parties are preparing rallies on the day to denounce the austerity policies supported by Germany, Greece's biggest creditor.
Data released on Thursday showed the unemployment rate stubbornly high at 26.7 percent in January, even though it dropped to the lowest level in 11 months.
Greeks' real disposable income has fallen by about 40 percent over the past six years. There has also been a wave of corporate bankruptcies while suicides have jumped by a third from pre-crisis level, prompting the opposition to speak of a "humanitarian crisis".
The fragile coalition led by Samaras has just a two-seat majority in parliament. The anti-bailout, leftist Syriza party, which has a slight lead in opinion polls, has accused Samaras of using the bond sale to score political points before European elections in May.
$1 = 0.7234 Euros Additional reporting by Costas Pitas and Renee Maltezou in Athens, and Emelia Sithole-Matarise and John Geddie in London. Writing by Harry Papachristou, editing by Giles Elgood and David Stamp