UPDATE 2-Portugal yields drop after president rules out snap vote
* Portugal parties fail to reach "national salvation" pact
* President supports coalition; bond rally seen capped
* German Bunds slip as world equities test 5-year high
LONDON, July 22 (Reuters) - Portugal's bond yields fell on Monday after its president ruled out a snap election following the collapse of talks among the three main political parties on a deal to support Lisbon's international bailout.
President Anibal Cavaco Silva said on Sunday he wanted the ruling centre-right coalition to stay in place to keep the rescue programme on track. He had demanded a "national salvation" pact to see the 78 billion euro bailout through to its scheduled conclusion next year, after a rift within the ruling coalition threatened to derail it.
Portuguese 10-year yields fell 50 basis points to 6.43 percent, their lowest in three weeks and 5-year yields dropped 60 bps to 6.03 percent, on relief elections that could have prolonged uncertainty had been avoided.
Portuguese bonds outpaced other euro zone debt. Ten-year yields were on course for their biggest one-day fall since October 2012, extending last week's retreat from near 8 percent, though thin volumes exaggerated the moves.
"In the short term this is slightly positive for Portuguese bonds as this support for the coalition is better for market stability than the alternative," said KBC strategist Mathias van der Jeugt.
Market participants, however, said the scope for further sustained falls in yields was limited as investors remained concerned about the fragile coalition's ability to steer Portugal out of its bailout in 2014 as planned.
A failure to issue new debt could force Lisbon to request another bailout, a burden investors fear official creditors may not be willing to carry alone, raising the possibility of a Greek-style restructuring.
"This maintenance of the status quo does nothing to address the divergences of opinion within the ruling coalition which are likely to return to the fore before too long," Rabobank strategists said in a note.
"Consequently, it would be wrong to take this morning's relief rally in Portuguese government bonds as signaling the all-clear in terms of Portuguese political risk and the threat this represents regarding the potential need for additional official creditor support."
Among other lower-rated euro zone debt, Italian and Spanish bond yields dipped as demand for riskier assets grew after Japanese Prime Minister Shinzo Abe's victory in weekend elections, which was seen as a boost for his stimulus policies.
Spanish 10-year yields fell 4 bps to 4.61 percent, with investors little fazed by pressure on Prime Minister Mariano Rajoy to explain his stance on a party funding scandal. Italian equivalents fell 5 bps to 4.36 percent .
German Bunds eased as world equities tested a five-year high after Abe's victory. Traders were also wary of putting on big bets before euro zone manufacturing activity and German IFO business sentiment data later in the week.