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By Emelia Sithole-Matarise
LONDON (Reuters) - Growing public protests against austerity have not blown Portugal's borrowing costs off course, suggesting investors still believe the European Union will make the country's bailout work.
A rise in bond yields triggered by the Constitutional Court's rejection on April 5 of some austerity measures has already been reversed, after the government scrambled to find alternative ways of cutting spending to secure rescue funds.
Like other indebted euro zone states, Portugal has benefited from the European Central Bank's pledge in September to buy bonds of countries that ask for help, which calmed market fears that the currency bloc might implode.
But the resilience of demand for its bonds following the court's ruling may encourage Lisbon to try selling new debt, a vital step towards exiting its bailout in mid-2014 as scheduled.
Improved risk-taking globally on the back of monetary easing by major central banks is also emboldening some investors to buy Portugal's bonds, overlooking its worst recession since 1970s. That could push 10-year yields back to three-year lows.
Yields on the country's 10-year bonds have fallen back to 6.2 percent, not far from a 2013 low of 5.8 percent, after spiking to 6.7 percent after the court's ruling. Current levels are close to those seen in October 2010, before Portugal was sucked into the debt crisis.
On Thursday, Lisbon all but assured release of its next aid tranche by approving alternative spending cuts to compensate for the measures rejected by the court. That raises chances that the EU will finalise a deal to extend the maturity of its bailout loans, as well as those of Ireland.
"At the moment the market is focusing on the idea that there is help coming in the form of the loan maturity extension because they 'stuck to the rules'," said Michael Michaelides, a strategist at Royal Bank of Scotland.
"In the current environment, where you still have an OMT (ECB bond buying plan) backdrop, people don't see any big blow-ups imminently. In that environment, Portugal starts to look more attractive compared to the other peripheral countries."
He is targeting a fall soon in the 10-year yield to 5.75 percent, which would take it closer to where higher-rated Spanish and Italian bonds traded in the latter part of 2012, after the ECB outlined its bond purchase scheme.
At current levels, Portuguese bonds are trading at a yield premium of 2 percentage points over Italy, the euro zone's third biggest economy. Its bonds offer a slightly bigger pick-up over those of bailed-out peer Ireland, which is on course to regain market access later this year before exiting its bailout.
Some bond market participants are already setting up trades favouring Portugal against Italy, where any scope for yields to fall below 2010 levels may be constrained by political deadlock following a February election that could stall its reforms.
"Portugal (yields are) coming in (versus) Italy and I think that's something we can continue for a little bit," said Jean Francois Robin, head of strategy at Natixis.
"That's on the basis that ... at best we will have an unstable government, and weak government, on the Italian side, (while) on the Portugal side everything that is coming out of the IMF is quite optimistic."
The International Monetary Fund is one of Portugal's "troika" of lenders, alongside the European Union and the ECB.
The country's sub-investment grade credit ratings will prevent some investors from buying its bonds, however, even if they find the yields offered attractive.
Portugal and Ireland have been the euro zone's model reform candidates since they were rescued two years ago after being shut out of capital markets as their debt burdens spiralled.
Under pressure to prove their rescue efforts are succeeding, and with a draconian rescue package for Cyprus and Italy's political impasse threatening a revival of the three-year-old debt crisis, euro zone leaders are keen to keep it that way.
Portuguese officials are also anxious to demonstrate the country can access the markets, which could help it qualify for the ECB's bond-buying scheme and ease the country's passage out of its bailout.
It took a first step in January, selling 2.5 billion euros of five-year bonds that drew strong demand, and finance minister Vitor Gaspar said before Cyprus's messy bailout unsettled markets in March that Portugal might issue more bonds.
With market conditions stabilising, some analysts say it could grab the opportunity to issue 10-year paper for the first time since 2011, especially if yields fall below 6 percent.
"We would expect the IGCP to go ahead with the launch (of a new 10-year bond) as soon as possible," Bank of America Merrill Lynch strategists said in a note.
"The tightening of 10-year spreads in the past week, as well as the decline in 10-year yields to close to 6 percent are setting a good momentum for the sale to take place once negotiations with the Troika are completed."
(Editing by Catherine Evans)