* Italy follows Spain's successful start to 2013 funding * Italy 3-yr borrowing costs at lowest in over 2 years * Bunds slip after Italy auction, ECB but off 5-week lows By Emelia Sithole-Matarise LONDON, Jan 11 (Reuters) - Italian bond yields fell on Friday after a strong debt sale, following euro zone peer Spain's successful start to the 2013 fund raising programme. Italian bonds outpaced low-risk German debt after the auction of 5 billion euros ($6.6 billion) worth of debt at which three-year borrowing costs fell below 2 percent for the first time since March 2010. Markets were also digesting Thursday's cautiously upbeat message from the ECB. Some strategists, however, warned that further outperformance against Bunds now looked limited after an aggressive rally over the past six months sparked by the European Central Bank's plans to buy bonds of struggling issuers, if they request conditional aid. "The rally has been aggressive and there's still carry to be had at the front end of Italian and Spanish curves but we're not so far from levels where at some point investors will try to re-evaluate the risk/reward of having exposure to Italy," said Alessandro Giansanti, a strategist at ING. Italian 10-year yields were last 3 basis points lower on the day at 4.14 percent, close to levels last seen in November 2010, squeezing their premium over Bunds by 3 bps to 258 bps. Equivalent Spanish yields were slightly lower too, having posted their second biggest daily fall in nearly three months on Thursday after a strong auction which some strategists said eased pressure on Madrid to seek a bailout in the next few months. HURDLES Some investors were, however, were starting to have doubts about the efficacy of adding to their exposure to Spain. "Coming into the new year, investors have looked at the yields available in other so-called risky assets and concluded that if Spain is guaranteed by the ECB then Spanish bonds are a very attractive relative investment," Martin Harvey, fund manager at Threadneedle Investments. "Investors are willing to put the fundamental vulnerabilities aside for now - at this point we are not," he said. Threadneedle manages 96 billion euros in assets and its European bond funds are benchmarked against the Merrill Lynch pan-European large cap index. Spanish bonds make up 5 percent of the index and Threadneedle's European Bond funds were underweight the index meaning only 2 percent of their holding is in Spanish government bonds and all short-dated. Low-risk German Bunds steadied on the day as investors were lured back by higher yields after a sharp sell-off on Thursday triggered by the ECB's lightly more upbeat view of the euro zone's economic outlook and dampened bets for an imminent rate cut. The Bund future was last 1 tick up on the day at 142.71 with 10-year German yields unchanged at 1.56 percent, having risen as high as 1.61 percent earlier. German two-year yields held at their highest level since October after ECB President Mario Draghi said policymakers were unanimous in holding interest rates steady at their meeting on Thursday Traders and strategists said the return of two-year yields into positive territory could lure back some investors into the front end of the German curve, given that official interest rates are set to remain at historic lows for an extended period. "Draghi's comments saying the decision on rates was unanimous and there was no debate on rate cuts is a significant change from December. But the door is not completely closed to further rate cuts but the market has to reassess the situation," said Patrick Jacq, a rate strategist at BNP Paribas.