* Yields drop, demand strong at 12-, 18-month debt sale
* Augurs well for bond auction on Thursday
* Country taps upturn in investor morale for 2nd year
* Fitch says Spain rating not secure, even if no bailout
By Fiona Ortiz
MADRID, Jan 15 (Reuters) - Spain saw its short-term borrowing costs sink on Tuesday in an auction that drew strong demand, tapping an upturn in investor sentiment to make early inroads into its debt issuance programme for the second year running.
The Treasury sold 3.2 billion euros ($4.28 billion) of a 12-month bill and 2.5 billion euros of an 18-month bill. Yields on both fell sharply, with the shorter paper dipping under 1.5 percent.
The sum raised beat the top end of the government's target, which was 5.5 billion euros.
Sentiment toward Spain - seen as a weak link in the euro zone due to its a high deficit and shrinking economy - has improved in recent weeks as yield-hungry foreign investors pile in, encouraged by the expectation that the European Central Bank would backstop the country if it needed a bailout.
"This was a really stellar auction, yields have dropped massively. This is part of the New Year rally we've been seeing in Italy and Spain and bodes well for Thursday's (bond) auction," said Jo Tomkins, strategist at consultancy firm 4Cast.
It plans to auction up to 4.5 billion euros of bonds due 2015, 2018 and 2041 on Thursday. After Tuesday's sale, the yield on Spain's benchmark 10-year bonds reversed a rise, falling to 5.025 percent..
While many investors still anticipate that Spain will request a bailout from the euro zone's rescue fund later this year, the immediate pressure for Prime Minister Mariano Rajoy to do so has eased as borrowing costs have come down.
According to a Reuters poll this week, 13 of 23 traders money market traders do not expect any euro zone country to make the request for aid this year that would trigger support via the ECB's bond-buying programme.
Daniel Pingarron, strategist with IG Markets brokerage in Madrid, said Tuesday's sale conveyed "a sensation of normality and absence of panic..."
"Taking into account that the 12-month bills are now yielding half of the inflation rate, that means that in inflation terms the Treasury is paying negative yield," he said.
Spain's consumer prices rose 2.9 percent year-on-year in December according to data released on Tuesday by the National Statistics Institute.
But deep-seated concerns about Spain's rising debt burden and an economy mired in recession and plagued by chronically high unemployment mean the country's funding position remains fragile.
Credit agency Fitch, which ranks Spain two notches above non-investment grade at BBB, said on Tuesday that rating would remain under threat for the next 12 months even if the country was able to avoid a financial rescue.
The other two main credit agencies, S&P and Moody's, rate Spain just one notch above 'junk'.
At the auction, the average yield on the 12-month bill was 1.472 percent, down from 2.556 percent at the previous sale one month ago, and it was 1.687 percent on the 18-month paper, down from 2.778 percent.
The last time the yields were around Tuesday's level was last March.
Demand on both bills was solid, with a bid-to-cover ratio of 2.2 on the 12-month paper, versus 2.5 on the last auction, and 2.7 percent on the 18-month bill, in line with the previous auction. The Treasury plans to discontinue the 18-month paper after the Tuesday sale, replacing it with a nine-month bill.
Spain's gross financing needs have shot up to 121.3 billion euros this year, 7.6 percent more than last year's total debt sales, due to piles of maturing debt as well as 23 billion euros earmarked to rescue regional governments that are shut out of debt markets.
With Tuesday's auction, Spain has completed 5.7 percent of the year's issuance plan, the Economy Ministry said in a statement.
Early last year Spain's government took advantage of lower borrowing costs to front-load a good chunk of its 2012 financing needs.
But in June, the auction yield on 12-month Spanish paper shot up beyond 5 percent.
The country's borrowing costs dropped steadily again from late summer, when ECB head Mario Draghi said the institution was prepared to buy bonds of countries that applied for aid.