* Markets more optimistic about BES financial stability
* Portuguese yields fall, but uncertainty persists
* Portuguese T-bill sale goes smoothly
* Investors see limited fallout from Espirito Santo problems (Updates with new comments)
By Marius Zaharia
LONDON, July 16 Portuguese bond yields fell on Wednesday, with investors more optimistic that the country's largest listed bank can deal with the financial troubles faced by its founding family, although uncertainty remained high.
Rioforte, which indirectly owns a stake in Banco Espirito Santo, was preparing to file for creditor protection in Luxembourg, where it is based. The news hurt Portuguese government debt in early trade, but the bonds recovered later as the stock market opened and BES shares rose.
The bank's shares have been recovering since late on Tuesday, when its chief executive said it was well capitalised and investor appetite for riskier assets picked up on the back of strong earnings from U.S. banks and dovish comments from Federal Reserve chief Janet Yellen.
The government and the central bank have repeatedly said BES is able to deal with any exposure to the troubled companies of its founding family as it has 2.1 billion euros in capital above the minimum regulatory requirements.
"The market is starting to come to terms with the situation regarding BES," said Gianluca Ziglio, an analyst at Sunrise Brokers. "Authorities in Portugal have been pretty clear that the bank is well capitalised."
He added, however, that uncertainty about the extent of the problems the Espirito Santo family was facing kept many investors nervous.
Portuguese 10-year government bond yields fell 8 basis points to 3.76 percent. They have regularly seen daily swings of more than 10 bps over the past week, having briefly broken above 4 percent in the process.
There was no sense of panic in debt markets.
The Portuguese government has a residual 6 billion euros from its rescue programme available for its banking sector if needed and the Treasury has built a financial buffer, having raised some of the funds it will need for next year.
"We're probably moving on to a phase in which the market thinks it doesn't necessarily have to lead to a spillover into the government bond market or other markets," said Rainer Guntermann, rate strategist at Commerzbank
The market for insurance against default suggests many investors see BES risks as localised.
Five-year Portuguese credit default swaps hit two-month highs of over 200 basis points last week, having risen from June lows of 126 bps. In comparison, CDS on BES hit nine-month highs of 500 bps, having traded as low as 148 bps in June.
Portuguese CDS last traded 183 bps, while BES's were 416 bps, both lower on the day, according to data from Markit.
Portugal sold the targeted 1.25 billion euros in Treasury bills, with the yield on the 12-month maturity rising slightly.
"The modest up tick in 12-month yields here should arguably be seen, at worst, as indicative of an element of caution," Rabobank strategist Richard McGuire said. "Meanwhile, the higher cover ratio ... potentially highlights the ready willingness of investors to buy on dips."
After a bout of contagion across euro zone peripheral bond markets last week, the other indebted countries traded independently of Portugal's woes this week.
Aliki Papasteriou, investment analyst at Nedgroup Investments, said the fears around BES have been "overplayed" and opened up a buying opportunity in peripheral debt markets.
A key reason for that is the European Central Bank's promise to offer banks up to 1 trillion euros in long-term loans from September at a rate of only 0.25 percent. The measure aims to encourage banks to lend to businesses and consumers, but if they don't they can pay back the loans for no penalty in 2016.
"Most of the tail risk in the euro zone has diminished and going forward support from the ECB ... should keep periphery yields tight at least until 2016," Papasteriou said. (Reporting by Marius Zaharia; Editing by Janet Lawrence)