Italy's six-month funding costs fell sharply on Friday to levels last seen before the country came to the fore of the euro zone debt crisis last summer, helping power a rally in its bonds ahead of Monday's more challenging sale of longer-dated debt.

The successful 11 billion euro bill auction followed a well-received short-term bond sale the previous day, reinforcing more positive market sentiment towards Italy ahead of its offer of five and 10-year bonds next week.

Rising hopes that Greece will strike a debt restructuring deal with its private creditors, clearing the way for a second bailout to avert a messy default in March, also helped drive down yields on Italian paper on Friday.

The fact that longer-term yields are finally falling shows some tentative signs of interest for Italian paper also among foreign investors, said Alessandro Giansanti, a strategist at ING in Amsterdam. It bodes well for Monday's auction.

This week's auctions were the first since Standard & Poor's cut Italy's long-term credit rating to BBB+ earlier this month as part of set of euro zone sovereign downgrades.

The European Central Bank's nearly half a trillion euros of ultra-cheap three-year loans to banks had boosted demand for short-dated Italian and Spanish debt in recent weeks, but investors had been less keen to buy riskier longer-term paper.

On Friday, however, the yield on the 10-year benchmark bond Italy will sell on Monday fell to 5.84 percent, the lowest level since the end of October.

Worries about Italy's ability to service its debt pile, the world's third-largest, peaked in November and precipitated a change of government. Rome has since striven to regain market confidence through belt-tightening measures and long-delayed measures to liberalise its economy.

Domestic banks are believed to have used part of the 116 billion euros they borrowed at December's unprecedented offering of three-year liquidity to snap up short-dated Italian debt which can be returned to the ECB as collateral, and its next three-year tender in February is seen further feeding demand.

But Italy also needs foreign investors to help it refinance some 90 billion euros of bonds falling due between February and April. Monday's sale of up to 8 billon euros of five- and 10-year bonds will provide 2012's first significant test of demand for these longer-dated securities.

SHORT-TERM ISSUANCE

Analysts caution it is too early to say Italy has turned a corner, but a fall in the interest bill on its short-term debt costs will help the country's push to cut its budget deficit.

A one percentage point drop in the average T-bill yield reduces interest payments by around 4 billion euros over a year, said Intesa Sanpaolo analyst Chiara Manenti.

At Friday's sale, Italy's six-month debt yields fell to 1.97 percent, well below the 3.25 percent it paid a month ago and dramatically lower from the euro lifetime record 6.5 percent investors demanded at an auction in November.

It was the lowest six-month auction yield since May - before a sell-off of Italian assets started in early July - and compared with the yield of 1.85 percent Spain paid this week to sell 1.1 billion euros of six-month bills.

As the market's focus appears to shift away from Italy and Spain, Portugal is back in the firing line as investors fret that Lisbon will follow Athens in seeking a fresh bailout and a debt restructuring.

Italy has said it plans to take advantage of firmer demand for short-term debt in the first part of the year but the outcome of Friday's sale showed heavier issuance may be weighing on demand. The 8 billion euro auction of six-month T-bills was covered 1.3 times, down from 1.7 times at a slightly bigger sale in late December.

The bid-to-cover ratio is the lowest in a year on T-bills. Nothing to worry about, but just a sign that the significant amount of bills the Treasury is pushing through may in the future turn out to be a little problematic, ING's Giansanti said.

(Additional reporting by Milan government bonds team; Editing by Catherine Evans)