By Andrei Khalip and Emelia Sithole-Matarise
LISBON/LONDON (Reuters) - Portugal sold benchmark debt at a record low yield on Wednesday in its first bond auction in three years, a vote of market confidence that boosts Lisbon's chances of making a clean break from its bailout next month.
Despite the relatively low return, demand easily outstripped the 750 million euros (595 million pounds) sold, suggesting Lisbon would enjoy strong investor support if it chooses to leave the rescue programme without the backstop of a standby European Union loan.
Whether Portugal follows Ireland in making a clean exit is a focal point of discussions with its international lenders, which began their last evaluation of its compliance with the terms of the programme on Tuesday.
"The more money they can raise at very low interest rates the more it gives them an incentive to go for a clean exit," said Lefteris Farmakis, a rates strategist at Nomura.
Prime Minister Pedro Passos Coelho said the auction gave the country "strong confidence about the future", though the government was still "calmly" weighing its options concerning a possible precautionary credit line.
It would reach a decision by May 5, when Europe's finance ministers are due to meet, he told an economic conference.
Debt agency IGCP placed Wednesday's bond at an average yield of 3.5752 percent, the lowest on record in a Portuguese auction of that maturity and significantly lower than the secondary market yield of 3.68 percent registered just beforehand.
Demand outstripped the amount placed by 3.5 times.
"It's now proven that Portugal can finance itself in the tough and rough normal market without support from banks," said Filipe Silva, head of debt at Banco Carregosa in Porto.
"The yield below the secondary market is very important as it shows that investors do not demand a premium for holding Portuguese debt."
In the market, the 10-year yield hit an eight-year low of 3.624 percent after the auction, according to Reuters data, outperforming other euro zone debt.
'SHOCKING' DROP IN YIELDS
That continued a trend of sharp declines since 2012 when the yield peaked at over 17 percent, driven by signs the euro zone crisis is abating, prospects of European Central Bank asset purchase and Portugal's own return to economic growth and lower deficits after a brutal recession.
As recently as February, Portugal paid 5.112 percent in a syndicated 10-year bond sale.
"(Wednesday's) result means that Portugal will probably be able to go it alone, which is nothing short of shocking considering where Portugal was just 10 month ago," said Nicholas Spiro, managing director at Spiro Sovereign Strategy consultants in London.
The latest leg lower in the country's yield took its premium over investment grade-rated Italy and Spain to around 60 basis points, a gap that many expect to narrow further as investors price in the prospect of credit agencies lifting Portugal's ratings in coming months.
Unlike Ireland, which exited its bailout in December without a supplementary credit line, Portugal managed to resume bond auctions before the end of its 78-billion-euro rescue programme.
Ireland did not hold its first post-bailout auction until last month, though at 2.967 percent its yield was much lower. Portuguese debt yields are close to where Irish yields were about a month before the end of Dublin's bailout.
"Funding at 3.5 percent for 10 years means it would be unlikely that (Portugal) would use a (precautionary line)," Nomura's Farmakis said.
"So in reality the difference between a (precautionary loan) as a backstop or not having one at all is not as large as perhaps commonly thought."
Other peripheral euro zone bond yields fell in Portugal's wake after the auction.
Speculation that the European Central Bank will begin an asset purchase programme to ease deflationary pressure in the euro area was also driving investor flows into peripheral bonds, where returns are relatively higher than in lower risk bonds.
Wednesday's debt sale was intended to help pre-fund Portugal for 2015.
"We are not desperate like three years ago, when we didn't have funding for one month. Now we have cash for a year," Passos Coelho said.
(Additional reporting by Sergio Goncalves and Daniel Alvarenga; Editing by John Stonestreet)