UPDATE 1-Portuguese bond rebound short-lived as crisis worries linger
* Concerns over debt sustainability weigh on Portuguese bonds
* Liquidity thin due to U.S. holiday, before ECB meeting
* Investors look to ECB for reassurance after market turmoil
LONDON, July 4 (Reuters) - An early rebound in Portuguese bonds, driven by government attempts to defuse its political crisis, was short-lived on Thursday as investors fretted over the country's ability to end its international bail out.
Two-year Portuguese yields jumped 41 basis points to 5.9 percent as investors sold and five-year yields rose to the psychologically important 7 percent level. Ten-year yields rose 6 basis points to 7.59 percent.
Financial market widely consider 7 percent to be unsustainably expensive if they remain for a period of time. Portugal is already subject to a European Union/International Monetary Fund bailout because raising money on regular markets became too pricey.
The resignation of two ministers this week, triggering prospects of a new election being fought over continued budget austerity, saw Portugal's 10-year sovereign yields spike on Wednesday above 8 percent, to near the levels at which it was forced to seek the bailout two years ago.
Thursday's yield rise was greater in shorter-dated bonds, suggesting investors are concerned about the country's ability to service its debt and, tentatively, about the potential losses to the private sector should Portugal have to restructure.
"The market is very nervous. The rebound was very short-lived (and) the (July 4) U.S. holiday is killing volumes," one trader said.
"They (investors) are worried about political risk in Portugal and a risk of a PSI-type event," he added, referring to so-called private sector involvement that forced losses on holders of Greek debt last year.
The difference between 10- and 2- year bond yields in Portugal has fallen more than 100 basis points in two days.
Traditionally, longer-dated bonds offer a comfortably higher return than short-dated ones to compensate investors for the risk of holding an asset over a longer period of time.
The turmoil in Portugal has dented investor appetite for other lower-rated debt, but Spain easily sold bonds albeit at a higher cost to the sovereign.
Madrid raised 4 billion euros - at the top end of the target. The new five-year bond attracted bids worth 1.7 times the amount on offer, while demand for a three-year bond was 3.5, higher than this year's 2.56 average.
"The recent Portuguese-driven correction has enhanced the attractiveness of Spanish bonds and the auction was taken down very well," said Nick Stamenkovic, bond strategist at RIA Capital Markets in Edinburgh.
"The outlook in Portugal is very clouded. What's interesting is that Italy and Spain have been relatively resilient."
Ten-year Spanish bond yields were up slightly at 4.76 percent and the Italian equivalent was 5.1 basis points higher at 4.57 percent.
Analysts expect demand from domestic investors and the European Central Bank's bond-buying programme to insulate Italy and Spain for now. Portugal does not immediately qualify for the programme.