* Portuguese bonds claw back some of Monday's losses
* Naked short selling ban on Banco Espirito shares stems sell-off
* Other lower-rated euro zone yields dip on ECB outlook (Adds fresh quote, updates prices)
By Emelia Sithole-Matarise
LONDON, July 1 Portuguese bond yields fell on Tuesday as worries eased that a probe into three holding companies of the country's biggest bank could create the type of financial instability that might force the government to act.
Uncertainty over Banco Espirito Santo since news of the investigation by Luxembourg's justice authorities drove its shares down around 16 percent on Monday, and prompted some investors to take profit on a sharp rally this year in Portuguese bonds.
"Portugal's bonds were hit because of the risk that the government may be needed to step in and support the banking system," said Alessandro Giansanti, senior rates strategist at ING.
"It looked like an overreaction though, and I don't think the banking sector in Portugal is a huge concern."
Finance Minister Maria Luis Albuquerque said last week Banco Espirito Santo was well-capitalised and the government saw no threat to financial stability and public accounts.
A rebound in Portugal's government bonds mirrored a recovery in BES shares after market regulators in Lisbon and London banned naked short-selling in the stock
BES shares earlier fell to their lowest since July last year, before reversing those losses to close up nearly 14 percent on the day.
Bond traders and analysts said the recent rise in Portuguese yields was attracting new buyers who were confident that the country was still on the right path with its fiscal reforms and would weather this round of negative news.
"Portugal has been one of those countries that's shown over time that it's doing the right things in terms of austerity," said Credit Agricole strategist Orlando Green. "Growth has been encouraging, they are able to fund at decent levels. Taking all this into account, it's not an issue than cannot be overcome."
Portuguese 10-year yields were last 6 basis points lower at 3.62 percent, having risen as much as 10 bps on Monday. They were, however, still about 40 bps up from 2005 lows around 3.25 percent hit three weeks ago.
Junk-rated Portugal successfully completed its bailout deal in May and returned to the bond market this year with regular debt auctions which have been well bid. The rejection of some budget cuts by the constitutional court caused only brief selling pressure in the market.
The bonds were among the best performers in peripheral euro zone bond markets in the first half after the European Central Bank took unprecedented monetary policy measures, fuelling a two-year rally.
Final data showing euro zone manufacturing activity eased in June to its lowest since November, confirming the bloc's feeble economic growth and the need for an accommodative ECB.
Weak inflation data on Monday has also served to reinforce bets the ECB could easy policy further, though the fact it did not deteriorate from May's 0.5 percent reading gave the bank room to hold off on further steps at this week's meeting.
"The ECB will certainly take this data into account and EMU inflation remains at a very low level and this rather supports the dovish tone of the ECB in general but not changing their view for now," said Christian Lenk, a strategist at DZ Bank.
"This should keep yields subdued but we don't expect much of a move before Thursday's ECB meeting and also the (U.S.) non-farm payrolls."
Spanish 10-year yields were 3 bps lower at 2.65 percent with Italian equivalents down 1 basis point at 2.74 percent. (Editing by Nigel Stephenson and Alison Williams)