Italian yields fall on auction, U.S. budget deal awaited
* Italy's 3- and 15-year borrowing costs fall at auction
* Greek 10-yr yields at 4-1/2-month low, Portugal follows
* German Bunds settle higher as markets still await budget deal
LONDON, Oct 11 (Reuters) - Italian yields fell on Friday after a well-received bond auction rounded up a week of solid sales from the euro zone's lower rated issuers as prospects of a potential U.S. debt deal lifted demand for riskier assets.
Even junk-rated Greek and Portuguese bonds rallied as investors renewed their search for yield, heartened by signs that politicians in Washington were willing to reach a deal to lift the country's debt ceiling and avert a near-term default.
President Barack Obama and congressional Republican leaders moved to end their fiscal impasse, but struggled to strike a deal on the details for a short-term reopening of the federal government and an increase in the U.S. borrowing limit.
The more benign market environment and easing political concerns in Rome after the government won a confidence vote last week helped drive Italy's borrowing costs sharply lower at a sale of up to 6 billion euros of bonds on Friday.
This rounded off a week of hefty debt sales in Rome and Madrid which drew robust interest from investors, in a sign of improved sentiment towards the euro zone's debt-ridden southern economies.
Italian 10-year yields were last 5 basis points lower at 4.28 percent, cutting its premium over German Bunds to their lowest in about three weeks at 242 bps.
Italian bonds have also regained ground against Spanish bonds, with 10-year yields falling below Spanish equivalents on Thursday after a new 7-year bond sale drew hefty demand. Spanish 10-year yields were 4 bps lower at 4.31 percent.
"The auction was pretty well received ... For most of the bonds, especially the longer dated, ones we have seen investors willing to overbid versus the mid-market. This shows how risk-seeking investors are," said Christian Lenk, a strategist at DZ Bank.
Greek 10-year yields hit their lowest in 4-1/2 months at 8.79 percent while Portuguese yields fell 19 bps to 6.26 percent, their lowest since June albeit in ultra-thin volumes.
"We see a pretty constructive environment for riskier euro zone government bonds," Lenk said. "It's a bit like the tide raising all ships given the positive developments we see surrounding the U.S. debt discussions where most likely at least a short term solution will be found in the next few days."
FOCUS ON U.S. DEBT
German yields held near three week highs, one day after they saw their biggest daily rise in a month on signs Washington was inching towards a short-term deal.
But German Bund futures settled 14 ticks higher on the day at 139.79 as investors grew more cautious ahead of the weekend and a U.S. public holiday on Monday.
"Although they are close to finding an agreement for at least a couple of weeks... that's not yet all settled so far, so we still don't have anything," David Schnautz, interest rate strategist at Commerzbank said.
"Heading into the weekend the market starts to get jittery and we have also seen this on the Treasury side."
U.S. House of Representatives Republicans were awaiting a White House response to their latest offer to raise the U.S. borrowing authority, which could help lead to an end to a government shutdown, now in its 11th day, a senior House Republican aide said.