* Portugal sells 5-year bond; demand strong
* Sale is Portugal's return to bond market post 2011 bailout
* IMF says markets getting ahead of the real economy
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Jan 23 (Reuters) - Portuguese debt yields fell to their lowest since late 2010 on Wednesday, with investors heartened by strong demand at the country's first bond market foray since its 2011 bailout.
Investors bid around 10 billion euros for Portugal's reopening of its October 2017 bond, five times more than the 2 billion euros the Treasury sold, allowing it to borrow at a lower than expected cost.
The result was expected to add momentum to the months-long rally in Portuguese debt, although room for further gains was limited by the sovereign's non-investment grade ratings.
Portuguese two-year bond yields fell 29 basis points on the day to 3.125 percent, their lowest since October 2010. Longer-dated yields also dropped to their lowest in more than two years.
Ciaran O'Hagan, rate strategist at Societe Generale in Paris, said demand was supported by the avoidance of large-scale fiscal tightening in the U.S., strong euro zone debt redemption flows, an improvement in economic sentiment indicators and a global search for yield.
"Portugal is the highest yielding sovereign in the euro zone with the exception of Greece, so if you want to ... (maximise) your yield return, Portugal is the place to be," O'Hagan said.
"Yields could go lower, but (the move) would be constrained by its ratings."
The syndicated deal followed Spain's launch of a new 10-year benchmark bond on Tuesday that drew unprecedented demand and recent successful auctions from Italy, setting the euro zone stragglers' 2013 fund raising efforts off to a solid start, thanks to renewed investor appetite for their debt.
Ten-year bond yields were down 5 bps at 5.80 percent, just 71 bps above those of higher-rated Spain.
They have tumbled from around 18 percent hit early last year as investors warmed to Lisbon's progress on fiscal reforms and stabilising peripheral markets in the last half of 2012 after the European Central Bank unveiled a new bond purchase scheme.
"It's been a very impressive performance but it's a small market now," said Lyn Graham-Taylor, a strategist at Rabobank.
"You're getting a convergence of spreads because of the liquidity not because there's been further steps towards a systemic solution of the crisis or because countries are suddenly returning to growth or got better fundamentals."
Reflecting similar worries, the International Monetary Fund said on Wednesday the markets were getting ahead of the real economy. The comments lifted peripheral yields off the day's lows and pushed safe-haven German Bund futures higher to last trade 52 ticks up on the day at 143.64.
Some in the market said the choice by Portugal to tap the 2017 bond appeared to be aimed at getting Lisbon closer to qualifying for the European Central Bank's programme of bond purchases, known as Outright Monetary Transactions, or OMT.
The programme is only available to countries that have normal access for long-term bonds.
"Portugal is some way away from getting full market access so the OMT is not on the horizon just yet but it's a step in the right direction," RIA Capital Markets strategist Nick Stamenkovic said.
"But the fact that Portugal is looking to raise money at this juncture clearly shows the authorities have noticed sufficient investor support out there and are taking advantage of conditions."
Basking in the afterglow of Tuesday's successful 10-year debt sale, Spanish bonds of that maturity yielded 5.09 percent , down 7 bps on the day with Italian equivalents little changed at 4.20 percent.
"There seems to be a lot of interest and hunt for yield so it's difficult to call an end to the rally in periphery," one trader said.