* Fitch to review Portugal rating on Dec. 15
* Fitch upgrade would give Portugal another investment grade rank
* Likely to trigger return to major bond indexes
* Portugal would regain exposure to larger pool of investors
* Sharp tightening in bond yield spreads
LONDON, Sept 28 (Reuters) - Portugal could return within months to major government bond indexes after an absence of more than five years - a stunning turnaround that could vastly increase potential investment in a country once ranked as one of the euro zone's weakest links.
After S&P Global on Sept. 15 lifted once bailed-out Portugal's rating one notch to BBB-, out of "junk" and into investment grade territory, investors are betting on further ratings upgrades that would allow Portugal to rejoin the big bond indexes.
This in turn would expose Portugal to a wider pool of investors, who only buy the sovereign bonds of countries that have an investment grade rating from the main ratings agencies.
Most major indexes, such as the Markit iBoxx euro benchmark index and the Bloomberg/Barclays euro aggregate index, which has a market value of over 10 trillion euros ($11.8 trillion), use the average ratings of Moody's, S&P and Fitch.
That means one more upgrade from either Moody's or Fitch would be enough.
Currently Portugal is included in the iBOXX EUR Sovereigns High Yield index, which has a market value of about 155 billion euros. An average rating of BBB or higher would push Portugal into the iBOXX EUR Eurozone index, which has a market value of around 5.9 trillion euros.
Should it be upgraded, Portugal would have a weighting of around 2 percent, the same as Ireland.
"Things get better once you get that stamp of approval with an investment grade rating, it does open up a broader market and typically a more liquid market," said David Tan, head of global rates at JPMorgan Asset Management.
Portugal is rated Ba1 by Moody's and BB+ by Fitch. Both have a positive outlook for the rating, making an upgrade likely.
Moody's reviewed Portugal on Sept. 1 and has not yet released its sovereign ratings review calendar for 2018.
Fitch, however, is scheduled to review Portugal's ratings on Dec. 15, making that the next possible date for an upgrade.
Deputy finance minister Ricardo Mourinho Felix told Reuters this week that Portugal expects to be upgraded soon by both Moody's and Fitch.
Rebalancing of bond indexes to reflect ratings changes typically take place at month-end, meaning the index is adjusted as of the following month.
One exception is the Citi Euro Broad Investment Grade Bond Index, for which S&P's upgrade alone is enough for Portugal to re-enter when it is rebalanced at the end of this month. The index has a market value of around 9.78 trillion euros ($11.52 trillion).
For Portugal to enter Citi's World Government Bond Index(WGBI), it would need a minimum credit rating of A- from S&P and A3 from Moody's. Portugal was added to the WGBI, which has a market value of around $21.38 trillion, in July 1998 and removed in February 2012.
BACK ON TRACK
Portugal first lost an investment grade rating in July 2011 when Moody's downgraded it into "junk" territory as its debt crisis unfolded.
Portuguese bond yields, which soared to over 17 percent in 2012, have since fallen back sharply, helped by European Central Bank buying, efforts to bring down the budget deficit and stronger-than-expected economic growth.
Regaining an investment grade rating is another step forward.
Mourinho Felix also told Reuters that investors had said they believed in Portugal's recovery story but that restrictions prevented them from investing in countries that did not have an investment grade rating from all three rating agencies. At the same time, Portugal offered comparatively low interest rates versus emerging markets.
"We were in 'no man's land.' It was the worst place to be because we were not good enough to have access to the investment grade portfolio, but we did not have enough risk to pay a return to those who wanted to invest in emerging debt markets," he said.
"The fact that we are now investment grade by one of the largest agencies allows a number of investors, who do not invest in indices but have their own portfolios, to buy Portuguese debt for their developed markets portfolios. This did not exist before."
The gap between Portugal's 10-year bond yield and top-rated German peers narrowed 39 basis points after S&P's upgrade -- the second largest one-day narrowing of the spread since Portugal exited its bailout in June 2014.
Analysts expected that spread and Portuguese yields to fall further, converging with Italy's, as investors anticipate a move into investment grade bond indexes. "The notion here is that the regaining of at least one investment grade rating represents something of a Rubicon, with this development being viewed as signaling the bailout era is over which, in turn, stands to herald a re-convergence of Portugal with its peripheral peers," said Richard McGuire, head of rates strategy at Rabobank in London.
Portugal's 10-year yield stood at 2.43 percent on Thursday. It has been one of euro zone's best performing bond markets in terms of returns this year.
"Portugal has been a pretty decent story for much of this year, but the move back to investment grade provides some political cover for investors to allocate more to the bond market there," said Patrick O'Donnell, investment manager at Aberdeen Asset Management.
(Additional Reporting by Sergio Goncalves in LISBON, Reporting and graphics by Dhara Ranasinghe; Editing by Nigel Stephenson and Catherine Evans)