* 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 Friday after a well-received bond auction rounded up a week of solid sales from the euro zone's lower rated issuers as prospects of a potential U.S. debt deal lifted demand for riskier assets.
Even junk-rated Greek and Portuguese bonds rallied as investors renewed their search for yield, heartened by signs that politicians in Washington were willing to reach a deal to lift the country's debt ceiling and avert a near-term default.
President Barack Obama and Republican leaders appeared ready to end the deadlock after meeting at the White House late on Thursday, and talks continued into the night with one senior Republican saying an agreement could come on Friday.
The more benign market environment and easing political concerns in Rome after the government won a confidence vote last week helped drive Italy's borrowing costs sharply lower at a sale of up to 6 billion euros of bonds on Friday.
This rounded off a week of hefty debt sales in Rome and Madrid which drew robust interest from investors, in a sign of improved sentiment towards the euro zone's debt-ridden southern economies.
Italian 10-year yields were last 3 basis points lower at 4.3 percent, cutting its premium over German Bunds to their lowest in about three weeks at 243 bps.
Italian bonds have also regained ground against Spanish bonds, with 10-year yields falling below Spanish equivalents on Thursday 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 the bonds, especially the longer dated, ones we have seen investors willing to overbid versus the mid-market. This shows how risk-seeking investors are," said Christian Lenk, a strategist at DZ Bank.
Greek 10-year yields hit their lowest in 4-1/2 months at 8.79 percent albeit while Portuguese yields fell 19 bps to 6.26 percent, their lowest since June albeit in ultra-thin volumes.
"We see a pretty constructive environment for riskier euro zone government bonds," Lenk said. "It's a bit like the tide raising all ships given the positive developments we see surrounding the U.S. debt discussions where most likely at least a short term solution will be found in the next few days."
German 10-year yields held near three-week highs with the Bund future three ticks lower at 139.62 as the firmer tone in lower-rated debt sapped demand for safe havens.
Bunds gave up early gains made in the wake of a rebound in U.S. Treasuries after a solid 30-year T-bond sale on Thursday.
German 10-year yields saw their biggest daily rise in a month on Thursday as signs Washington was inching towards a short-term deal cooled demand for safe havens and lifted riskier assets.
"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 some short-term agreement on raising the debt ceiling so risks are more to the downside for core bonds because of the U.S. holiday on Monday but I don't expect a big move."
Very short-term U.S. Treasury bill rates have come off peaks hit this week as signs of progress have emerged. Some in the market still saw risks, with a potential deal before Monday's U.S. public holiday seen providing only a brief respite.
"Looking beyond the very short-term, then, this could have negative implications somewhat further down the road," Rabobank strategists said in a note.
"Indeed, while this hard borrowing limit would avoid a potential default scenario in the very near future, there is a risk that, if the Democrats and Republicans cannot make a deal in time, the government will approach another potential default scenario towards the end of November. This might then startle markets again."