* Italy's 3- and 15-year borrowing costs fall at auction
* Prospects of break in U.S. debt impasse aids risk taking
* Greek 10-yr yields at 4-1/2-month low, Portugal follows
* German 10-year yields rise, at highest in nearly 3 weeks
By Emelia Sithole-Matarise
LONDON, Oct 11 (Reuters) - Italian yields dipped on Fridayafter a well-received bond auction rounded up a week of solidsales from the euro zone's lower rated issuers as prospects of apotential U.S. debt deal lifted demand for riskier assets.
Even junk-rated Greek and Portuguese bonds rallied asinvestors renewed their search for yield, heartened by signsthat politicians in Washington were willing to reach a deal tolift the country's debt ceiling and avert a near-term default.
President Barack Obama and Republican leaders appeared readyto end the deadlock after meeting at the White House late onThursday, and talks continued into the night with one seniorRepublican saying an agreement could come on Friday.
The more benign market environment and easing politicalconcerns in Rome after the government won a confidence vote lastweek helped drive Italy's borrowing costs sharply lower at asale of up to 6 billion euros of bonds on Friday.
This rounded off a week of hefty debt sales in Rome andMadrid which drew robust interest from investors, in a sign ofimproved sentiment towards the euro zone's debt-ridden southerneconomies.
Italian 10-year yields were last 3 basispoints lower at 4.3 percent, cutting its premium over GermanBunds to their lowest in about three weeks at 243 bps.
Italian bonds have also regained ground against Spanishbonds, with 10-year yields falling below Spanish equivalents onThursday after a new 7-year bond sale drew hefty demand. Spanish 10-year yields were 2 bps lower at 4.33 percent.
"The auction was pretty well received ... For most of thebonds, especially the longer dated, ones we have seen investorswilling to overbid versus the mid-market. This shows howrisk-seeking investors are," said Christian Lenk, a strategistat DZ Bank.
Greek 10-year yields hit their lowest in 4-1/2months at 8.79 percent albeit while Portuguese yields fell 19bps to 6.26 percent, their lowest since June albeit inultra-thin volumes.
"We see a pretty constructive environment for riskier eurozone government bonds," Lenk said. "It's a bit like the tideraising all ships given the positive developments we seesurrounding the U.S. debt discussions where most likely at leasta short term solution will be found in the next few days."
German 10-year yields held near three-week highs with theBund future three ticks lower at 139.62 as the firmertone in lower-rated debt sapped demand for safe havens.
Bunds gave up early gains made in the wake of a rebound inU.S. Treasuries after a solid 30-year T-bond sale on Thursday.
German 10-year yields saw their biggest daily rise in amonth on Thursday as signs Washington was inching towards ashort-term deal cooled demand for safe havens and lifted riskierassets.
"Risks if anything are more to the downside for core bonds,"said Mathias van der Juegt, a strategist at KBC in Brussels.
"I believe the chances are higher that we might get someshort-term agreement on raising the debt ceiling so risks aremore to the downside for core bonds because of the U.S. holidayon Monday but I don't expect a big move."
Very short-term U.S. Treasury bill rates have come off peakshit this week as signs of progress have emerged. Some in themarket still saw risks, with a potential deal before Monday'sU.S. public holiday seen providing only a brief respite.
"Looking beyond the very short-term, then, this could havenegative implications somewhat further down the road," Rabobankstrategists said in a note.
"Indeed, while this hard borrowing limit would avoid apotential default scenario in the very near future, there is arisk that, if the Democrats and Republicans cannot make a dealin time, the government will approach another potential defaultscenario towards the end of November. This might then startlemarkets again."