Yield hunt ensures smooth market return for bailed-out Cyprus

* Cyprus sells 750 mln euro bond at 4.85 percent

* Five-year bond offers highest returns in euro zone

* Returns to markets just a year after bailout

* ECB easing fuels risk appetite, hunt for yield (Adds bond pricing, comments from Cyprus finance minister)

By John Geddie and Michele Kambas

LONDON/NICOSIA, June 18 (Reuters) - Cyprus returned to markets on Wednesday little more than a year after it was bailed out, with investors snapping up a five-year bond that offered the highest yield of any comparable euro zone debt.

Its comeback - the fastest of any country rescued by euro zone peers during the bloc's debt crisis - comes while capital controls are still in place following its 10 billion euro EU/IMF bailout, which also imposed losses on bank depositors.

But with ultra-loose central bank monetary policy having pushed the returns on fixed income assets to historic lows, the 4.85 percent yield on offer for the 750 million euro bond drew orders of around 2 billion euros.

"We put in a bid not because Cyprus is the soundest credit in the world, but because there's a hunt for yield going on and the bonds will perform," said Guido Barthels, CIO at Luxembourg-based Ethenea. "What else is there to buy in the euro space?"

Cyprus initially sought to raise 500 million euros from the sale but raised it to 750 million after strong demand from investors, Finance Minister Harris Georgiades said.

He told reporters that the sale was a step towards Cyprus' "systematic" return to markets after a three-year hiatus and pledged the country would not let up on its fiscal reforms.

The sale attracted investors mainly from Britain, other European countries and Cyprus, with investment funds absorbing 51 percent of the issue, hedge funds 27 percent and banks 22 percent, the finance ministry said in a statement.

It comes two months after twice-bailed-out Greece sold a new five-year bond at a yield of 4.95 percent - one of the swiftest returns to markets by any country following a default. Those bonds have since rallied to yield 4.25 percent, according to Tradeweb, giving investors a quick profit.

Barthels at Ethenea was hoping the Cyprus deal would also offer immediate gains. He said he planned to sell the bonds when the yield reached 4 percent in secondary markets.

YIELD HUNT

Cyprus has not borrowed on international markets since May 2011, at the height of the euro zone's debt crisis, when high yields on its existing bonds made external borrowing impossible.

Last year lenders extended the island a 10 billion euro financial lifeline, conditional on an economic adjustment plan, after its banking system imploded. The deal included a debt exchange that ratings agencies classed as a default, and Cyprus's credit ratings remain deep in junk territory.

Under its adjustment plan, Cyprus was not seen returning to financial markets until the end of 2015, but improving market conditions have accelerated its comeback.

"The ongoing hunt for yield continues to see the market very receptive to bailed-out countries looking to make a comeback and the success of these comebacks, in turn, further underpins positive sentiment for the country in question," Rabobank analysts said in a note on Wednesday.

Georgiades said that the cash raised would go towards refinancing domestic debt. With Wednesday's bond issue, the cost of servicing debt would be "clearly lower" than 3 percent, compared with just over 3 percent at present, and 4.3 percent a year ago, he said.

Returns on all euro zone sovereign bonds have been squeezed, to record lows in many cases, as the European Central Bank has pumped the market with liquidity and cut interest rates so far that some have turned negative.

This dynamic is expected to further fuel investor appetite to take higher risks to maximize profits, exacerbating fears that some bonds have become overvalued.

"The risk is that valuations and primary market dynamics aren't related to fundamentals anymore," said Michael Leister, senior strategist at Commerzbank.

Vanguard Group Inc's new bond chief, Gregory Davis, said investors could be ignoring warning signs in less stable countries in their search for yield.

Cyprus's economy is shrinking as the terms of the bailout bite, although a forecast contraction of 4.2 percent this year is less than the 4.8 percent initially expected and some see the decline in output at closer to 3 percent. The IMF expects a return to growth in 2015, at a modest 0.9 percent rate, after three years of recession.

That hasn't put off investors, however.

"It's not a domestic issue, it's a European issue. People are searching for yield," said Martin Wilhelm, founder of IfK, a bond boutique based in Kiel, Germany, which runs a bond fund with Acatis and placed an order for the new Cypriot paper.

In other euro zone government bond sales on Wednesday, Spain auctioned 3.1 billion euros of 3- and 5-year bonds at record low yields while Germany sold 4.108 billion euros in 10-year bonds.

(Additional reporting by Sarka Halas at IFR and Emelia Sithole and Marius Zaharia at Reuters; Editing by Catherine Evans and Susan Fenton)