* Portugal parties fail to reach "national salvation" pact
* President says coalition to stay; bond rally seen capped
* Italian, Spanish bonds gain as world equities rally
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, July 22 Portugal's bond yields fell on Monday after its president ruled out a snap election following the collapse of talks among the main political parties on supporting Lisbon's bailout.
President Anibal Cavaco Silva said on Sunday he wanted the ruling centre-right coalition to stay in place to keep the rescue programme on track. He had demanded a "national salvation" pact to see the 78 billion euro bailout through to its scheduled conclusion next year, after a rift within the ruling coalition threatened to derail it.
Portuguese 10-year yields fell 54 basis points to 6.47 percent and five-year yields dropped 61 bps to 6.02 percent, on relief elections that could have prolonged uncertainty had been avoided.
Portuguese bonds outpaced other euro zone debt. Ten-year yields posted their biggest one-day fall since Jan. 2, extending last week's retreat from near 8 percent.
The cost of insuring Portuguese debt against default via five-year credit default swaps fell 40 bps to 462 bps, according to data monitor Markit. That was some 80 bps lower than its peak on July 12 but still almost 200 bps above levels two months ago.
"They have found a good temporary solution to their crisis ... government stability is the most important thing in all the peripheral countries," one trader said. "The market has stepped back from the brink at least for now."
Market participants said the scope for further sustained falls in yields was limited as investors remained concerned about the fragile coalition's ability to steer Portugal out of its bailout in 2014 as planned.
Failure to issue new debt could force Lisbon to seek another bailout, a burden investors say official creditors may be unwilling to carry alone, raising the possibility of a Greek-style restructuring.
"It would be wrong to take this morning's relief rally ... as signalling the all-clear in terms of Portuguese political risk and the threat this represents regarding the potential need for additional official creditor support," Rabobank strategists said in a note.
A second trader said buying interest came mainly from domestic investors and cautioned against reading too much into the Portuguese rally given low volumes.
An indication of the thin trade was the gap between the price bidders were willing to pay and that which holders wanted, which remained at over 2.5 cents in the euro, similar to levels seen since the political crisis began earlier this month. In most other euro zone markets the gap was around 0.1 cents.
Among other lower-rated euro zone debt, Italian and Spanish bond yields dipped as demand for riskier assets grew after Japanese Prime Minister Shinzo Abe's victory in weekend elections, which was seen as a boost for his stimulus policies.
Spanish 10-year yields fell 5 bps to 4.60 percent, with investors unfazed by pressure on Prime Minister Mariano Rajoy to explain his stance on a party funding scandal. Italian equivalents fell 8 bps to 4.33 percent.
Benchmark German 10-year yields were flat at 1.52 percent.