* Cyprus set to sell 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 fresh quotes, deal updates)
By John Geddie and Sarka Halas
LONDON, June 18 (Reuters/IFR) - Cyprus returned to markets on Wednesday little more than a year after it was bailed out, with investors expected to snap up the five-year bond, which offers 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 the aid deal, 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 has already drawn orders of around 2 billion euros, bankers working on the deal said.
"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 is set to price the 750 million bond, which matures in June 2019, later on Wednesday.
Bankers working on the deal said UK investors had placed a significant share of the orders, with fund managers and hedge funds also involved.
The sale comes just 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.
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.
Cypriot government sources told Reuters the bond would be used to refinance maturing debt, while one senior official added it was not designed to arrange an early exit from its bailout.
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.
As a direct result of the ECB charging banks to keep their money in overnight deposits, Germany and the Netherlands sold treasury bills at a negative yield on Monday.
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.
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 positive 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 German Kiel-based bond boutique, which runs a bond fund with Acatis and has 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 tapped its 10-year bond by 4.108 billion euros.
(Additional reporting by Marius Zaharia in London and Michele Kambas in Nicosia; Editing by Catherine Evans)