* Italian, Spanish 5-yr yields at lowest in at least 20 years
* Euro zone factory recovery strongest in 2-1/2 years
* German 5-year bond sale draws lacklustre demand
By Emelia Sithole-Matarise
LONDON, March 5 (Reuters) - Spanish and Italian five-year yields hit fresh historical lows on Wednesday after surveys showed robust growth in the euro zone's service industry, adding to signs the bloc's southern economies are strengthening.
Euro zone private businesses enjoyed their fastest growth rate in over 2-1/2 years last month, as the bloc's services sector expanded faster than initially thought.
The Markit composite purchasing managers' indexes for Italy and Spain, the euro zone's third and fourth biggest economies, both beat forecasts and came in above the 50 mark that separates growth from contraction.
Germany again led the upturn in the 18-member bloc's fortunes, but the services PMI for France, the region's no.2 economy, slipped to 47.9, further below the breakeven mark where it has languished for most of the last two years.
The readings strengthened investors' view that the economic recoveries in Spain and Italy, crucial to curb high debt levels, are gaining ground.
Spanish five-year yields were down 4 basis points at 1.90 percent, falling further below 2 percent to their lowest in at least 20 years, according to Reuters data. Italian equivalents were also lower by a similar amount at 1.93 percent.
Yields on both countries' 10-year bonds dipped further to new eight-year lows. Italy's 10-year debt was yielding 3.38 percent and 3.39 percent respectively, their lowest since late 2005.
Improved outlooks on the two countries' creditworthiness and easing investor worries about the euro zone debt crisis have also sharpened investors' appetite for their government bonds, driving borrowing costs to multi-year lows.
"This (PMI data) is simply confirmation of the trend that we see a substantial rebound in the periphery and prompts investors to add positions in a segment of the European government bonds where you still get a decent amount of yield," said Christian Lenk, a strategist at DZ Bank.
Although Italian and Spanish bonds have rallied sharply so far this year, they still offer higher potential returns than top-rated German bonds where yields are a fraction of peripheral euro zone yields.
Recent strains in emerging markets (EM) have also fed the bond rally, underpinned by signs of recovery in the euro zone and the European Central Bank's pledge to buy government bonds, under strict conditions, if a country gets into trouble.
"We continue to see scope for it (EM crisis) proving positive for peripherals as investors wanting to shift out of EM look for 'relative' safety while giving up as little yield as possible," Rabobank strategist Richard McGuire said.
German 10-year Bund yields, the benchmark for euro zone borrowing costs, were up 2 bps at 1.62 percent following the PMIs. Improved risk-taking ahead of talks between the United States and Russia on easing tensions over Ukraine also sapped demand at an auction of German debt.
Berlin sold 3.27 billion euros of five-year bonds, drawing bids worth 1.4 times the amount offered versus 1.7 at last month's sale. It was, however, better than last week's 30-year bond auction which was shunned by investors due to its low potential returns, and a 10-year debt sale the week before which met similarly poor appetite.
Five-year German yields were up 1 basis point at 0.64 percent in the secondary market with further rises tempered by caution ahead of the ECB's policy meeting on Thursday.
Money markets show little likelihood of further monetary policy easing from the ECB this week after slightly forecast-beating inflation data last week. Many still expect the ECB to act later this year as inflation is predicted to stay way below the central bank's target of below but close to 2 percent, potentially threatening the euro zone recovery.