UPDATE 2-Portugal yields fall as Lisbon works to defuse political crisis
* Investors remain nervous before June 21 Portugal deadline
* Spanish debt market shrug off growing political tensions
* German Bunds rise after below-forecast German ZEW data
* Focus turning to Bernanke testimony Wednesday, Thursday
LONDON, July 16 (Reuters) - Portuguese bond yields fell on Tuesday as political parties sought agreement on austerity required under the country's bailout deal, with investors anxious further aid may be needed.
Portuguese bonds firmed in a stable euro zone market with Prime Minister Pedro Passos Coelho expected to survive a vote of no confidence due on Thursday called by the smaller Green Party.
Questions remained over whether Passos Coelho and Socialist Party leader Antonio Jose Seguro can reach agreement by a July 21 deadline given their divergence on austerity policies.
President Anibal Cavaco Silva last week rejected the premier's bid to heal a rift in the ruling coalition via a cabinet reshuffle, calling for a cross-party agreement to last until the end of the bailout programme in June 2014.
Investors are concerned a prolonged crisis could lead to a second bailout, forcing official creditors to suggest wider debt restructuring involving private sector haircuts (PSI).
Five-year yields fell 20 basis points to 7.06 percent while 10-year yields were down 16 bps at 7.23 percent, retreating from highs near 8 percent hit last week after Lisbon delayed a review of its bailout due to the crisis.
Although five-year bonds recouped some of last week's losses, the 5/10-year yield gap was near its narrowest since June 2012, reflecting elevated credit risk.
"The market remains nervous and the reason why the curve has aggressively flattened at the front end is that people are getting concerned that some kind of haircut may be required before they can get back to the market," said Rabobank strategist Lyn Graham-Taylor.
"I still think we are a long way from that possibility being discussed."
RESILIENT SPANISH BONDS
Most other euro zone bonds firmed, with Bunds rallying after German investor and analyst sentiment unexpectedly fell in July, reflecting economic tension in the bloc.
Bund futures were last 30 ticks up on the day at 143.69, reversing earlier falls, with German 10-year yields 2 bps lower at 1.55 percent.
Gains were, however, seen capped by caution before U.S. Federal Reserve Chairman Ben Bernanke's semi-annual congressional testimony on Wednesday and Thursday.
The Spanish market shrugged off pressure on Prime Minister Mariano Rajoy over a party financing scandal. Rajoy on Monday rejected opposition calls for him to quit and said his reform plans would not be held back.
Investor faith in the European Central Bank's bond purchase backstop, for which Madrid qualifies with its uninterrupted access to capital markets, in contrast to Lisbon, has largely shielded Spanish debt from contagion from Portugal.
Spanish 10-year yields fell 4 bps to 4.66 percent while equivalent Italian yields were unchanged at 4.47 percent.
RBC strategists, however, urged caution against extending exposure to Spanish bonds beyond shorter-dated maturities that fall within the scope of the ECB bond buying scheme that has eased the debt crisis over the past year.