* Spanish yields fall after auction * Spain sells larger-than-expected 4.6 bln euros of bonds * Bund sell-off pauses, but ongoing pressure seen By Kirsten Donovan LONDON, Oct 18 (Reuters) - Spanish government bond yields fell on Thursday after strong demand at a debt sale further fuelled an improvement in sentiment towards the country, which hung on to its investment-grade credit rating earlier this week. Spain sold 4.6 billion euros of 2015, 2016 and 2022 bonds. The amount bid for the 10-year paper rose in absolute terms versus the previous sale, an important indicator of investor confidence as the paper is outside the scope of the European Central Bank's bond-buying plan. Sentiment towards Spain has brightened this week after Moody's affirmed the country's Baa3 credit rating, just one notch above "junk" grade, and with Madrid expected to ask its euro zone peers and the ECB for aid soon. "That they managed a higher allocation at the long end ... is very encouraging. But it was somewhat expected given Moody's decision and improving risk sentiment," said Nomura rate strategist Artis Fankovics. "If sentiment continues to improve, we'll probably see them tap bonds with higher maturity ... But I doubt at this stage they will issue a new 10-year bond because it's a high-risk strategy." An aid request - which Moody's said in its rating statement it expected - would clear the way for the ECB to buy Spain's bonds, a move that should prevent yields heading back towards unsustainable levels. Yields on 10-year Spanish debt exceeded 7.6 percent in late July. After the auction the yield was 5.42 percent, 8.5 basis points lower on the day and the lowest for more than six months. The spread between Spanish paper and low-risk German Bunds stood at 377 basis points after falling below 400 bps for the first time since April on Wednesday "There's been some buying of Spain, some covering of short positions and decent (cash) flow into the periphery so the money is behind the ECB at this point, and if they come in aggressively and are successful then there's certainly more room for spreads to converge," said ING's head of investment grade strategy Padhraic Garvey. European Union leaders meeting in Brussels were set to focus on plans for a banking union, with discussions about Spain and even Greece confined to the sidelines - reviving concerns about complacency in tacking the three-year old debt crisis. France also sold 8 billion euros of shorter-dated debt, again seeing its borrowing costs fall. "There was really strong bidding on all lines and the allocation of five-year paper is larger than expected," said Credit Agricole rate strategist Peter Chatwell. "The price action in OAT futures suggests that demand for French paper has still not been satisfied yet, so the secondary market is likely to trade well." French bond futures were unchanged on the day at 134.40, having fallen as low as 134.06 immediately before the auction. German Bund futures were 2 ticks lower at 139.73, although trading was choppy. "(Interest) rates aren't going up so it's questionable how far Bunds can sell off," a trader said. "But you're looking at the carry trade into year end and even though some of those semi-core spreads over Bunds are looking a bit compressed, it's hard to fight it just now," he said, referring to market players selling lower-yielding bonds and buying higher-yielding bonds. The French 10-year yield spread over Bunds, for example, has fallen to just 50 bps, its lowest since July 2011, while the equivalent Dutch spread at 22 bps is the lowest since March 2011. German 10-year yields were little changed at 1.64 percent, near the 1.70 percent top of the recent trading range after rising a total 15 bps on Tuesday and Wednesday. "We wouldn't expect the recent move to be reversed to a significant extent, the path of least resistance for now is to higher yields," Garvey said. "It's a positive tone out there from a spread perspective and that hasn't been reflected fully in Bunds yet."

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