* Portugal's 10-year bond yield down 35 bps
* Yield gap with Germany tightest since January 2016
* Portugal returns to investment grade after 5 1/2 years
* S&P first of big three ratings firms to lift Portugal back
* Portugal leads European shares to six-week high (Updates prices)
LONDON, Sept 18 (Reuters) - Portugal's 10-year bond yield hit its lowest level since January 2016 on Monday, driven by the country regaining an investment- grade credit rating after 5 1/2 years, effectively drawing a line under its debt crisis.
Standard & Poor's on Friday became the first of the big three credit-rating agencies to lift Portugal back to investment grade, citing its improving economy and public finances. It raised its rating to BBB-, the lowest investment grade, with a stable outlook, from BB+, with a stable outlook.
Portugal lost the investment-grade rating, which widens the investor base for a country's bonds, at the height of its debt crisis in January 2012.
With the exception of Greece, which is still in a bailout programme, and Cyprus, all euro zone member states are now rated investment grade by at least one of the big three rating firms.
Since ratings agencies often change the outlook on a country before they change the ratings, S&P's move took markets by surprise. Investors reacted by pushing up stock and bond prices, - which move in the opposite direction to the yield. "The ratings upgrade is a move we agree with - it is clear that the economy has recovered significantly and progress made by policy makers has been beneficial to the recovery," said Peter Chatwell, head of euro rates strategy, at Mizuho. Portugal's 10-year bond yield slid as much as 35 basis points to 2.45 percent, its lowest level since January 2016.
The yield was on track for its biggest one-day fall since February 2016 and was by far the biggest outperformer in euro zone bond markets. The drop dragged the gap over top-rated German Bund yields below 200 basis points for the first time since December 2015.
Spanish yields fell 2 basis points, dragged down by Portugal, and the Italian and Irish equivalents were flat higher-rated bond yields were 1-2 basis points higher on the day.
Portuguese stocks also outperfomed their peers with the PSI 20 up 1.5 percent. Financials provided the biggest lift to the index, with Bank BCP Millenium up 6 percent.
The upgrade is likely to attract more portfolio investment and has sparked speculation about Portugal's inclusion in major investment grade bond indices.
"Now the markets are looking at a formal entry into bond market indices and some of these need two investment grade ratings," said Patrick O'Donnell, an investment manager at Aberdeen Asset Management.
"At this stage, we're getting close to pricing that reflects a return to these indices."
Portuguese government bonds have been among the euro zone's best performing markets this year, marking a turnaround from jitters about Portugal's rating outlook at the end of last year.
An economic recovery and efforts to lower the country's budget deficit have boosted sentiment - just as the positive impact of the European Central Bank's asset-buying programme is subsiding.
Lisbon last year chalked up its smallest budget shortfall since 1975, and in June the European Council ended a disciplinary process against Portugal, which only emerged from a three-year international bailout in 2014, over its excessive deficit.
"There are investors who simply could not buy Portuguese debt before (the upgrade) due to investment rules, even when it behaved strongly in terms of returns," Portuguese Finance Minister Mario Centeno told Reuters.
"And now they will be able to buy it, which is very good as it will be a decisive help toward the ongoing government effort of diversifying the investor base."
(Reporting by Dhara Ranasinghe; Additional reporting by Danilo Masoni in Milan and Andrey Khalip and Sergio Gonclaves in Lisbon; Editing by Larry King)