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UPDATE 1-Portugal's bond yield gap over Italy shrinks to pre-crisis levels

* Demand soars for Portugal as country wins back investment rating

Portugal-Italy yield spread tightest since March 2010 at 33 bps

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr

By Abhinav Ramnarayan

LONDON, Sept 19 (Reuters) - The gap between Portuguese and Italian 10-year government bond yields narrowed on Tuesday to levels not seen since the start of the euro zone debt crisis of 2010-2012.

This follows a strong rally in Portuguese debt over the last two sessions after S&P Global became the first major ratings agency to give the country back an investment grade rating on Friday, more than five years after it first sank into junk territory.

The rally has seen Portuguese borrowing costs come closer to that of its larger, better-rated south European neighbours, even if it is still the highest yielding of the three.

"It reflects the narrowing ratings differential and the fact that some political risk premium is still baked into Italian government bonds," said ING strategist Martin van Vliet.

Portugal's 10-year government bond yield spread over Italy narrowed to 33.5 basis points, the lowest since March 2010. At the start of the year, that difference was as high as 211 basis points.

In absolute terms, Portugal's 10-year government bond yields dropped 9 basis points to 2.40 percent on Tuesday.

Van Vliet said Portugal's recovery from the euro zone debt crisis - when it needed a bailout from European authorities - is a strong story, but cautioned that it is still a weaker credit than Italy because of its external debt position.

Portugal's outstanding private debt stood at 280 percent of the country's economic output last year, comprising 178 percent for companies and 103 percent for households. <http://reut.rs/2xiwTjp

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"I think this rally is on speculation that Portugal could now be included in many benchmark indices," Van Vliet said.

Many large bond indexes provided by investment banks only include investment grade borrowers, and inclusion in these usually guarantees a new influx of investors and lower yields.

However, many index providers require an investment grade rating from at least two of the three main credit ratings agencies, and Portugal now only has one. It is rated Ba1 by Moody's and BB+ by Fitch.

Portugal was by far the outperformer in bond markets on Tuesday, but other euro zone yields also edged lower on the day ahead of a key U.S. Federal Reserve meeting, which concludes on Wednesday.

The central bank of the world's biggest economy is expected to provide details on how it will reduce a massive balance sheet run-up through years of post-crisis money printing.

This is seen as significant by European investors as the ECB is also expected to tighten policy, possibly by announcing in October its plans for ending its own money-printing scheme.

A 2 billion euro sale of German 30-year bonds on Wednesday should show which way investors see this as going - longer-dated bonds are more sensitive to changes in monetary policy.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.bi z / c m s / ? p a g e I d = l i v e m a r k e t s

(Reporting by Abhinav Ramnarayan; Editing by Hugh Lawson)