Shares in Banco Espirito Santo slumped again on Tuesday, dragging European markets lower, as sources told Reuters a key shareholder was preparing to file for creditor protection. Worries about the bank had hit global appetite for risk last week.

As the euro zone's debt crisis has receded since 2012, helped by the European Central Bank's pledge to save the euro and measures to contain future problems such as banking union, cash has flooded into countries like Italy, Spain and Portugal.

Investors are by and large sticking to their bullish positions as the BES crisis rumbles on. But there is growing awareness that high valuations and unresolved problems such as stuttering growth and an interdependent financial system are likely to cause jitters down the line.

"We do not think the problems emanating from the BES debacle should be seen as a systemic issue for the sovereign, and feel that the contagion effects are overdone," said Martin Harvey, European bond manager at Threadneedle Investments.

"Having said that it is a reminder that peripheral nations will continue to face sporadic mini-crises due to the deep structural problems their economies and financial systems face."

Investors are also conscious of the fact that in a world of rock-bottom interest rates - and with potential ECB bond-buying to come - the pressure to hunt for yield will persist.

Lisbon-listed BES shares hit a record low early in the trading day and ended the day down 14.6 percent after sources told Reuters that shareholder Rioforte was preparing to file for creditor protection.

The move pushed up yields on Portuguese and Greek debt, though investors were on hand to buy into the weakness and settle the market rather than call a stop to the trade entirely.

"A lot of the value in the periphery has dissipated but on any big sell-off in any of these countries we would more likely be buyers than sellers," said Alan Higgins, chief investment officer at Coutts, which manages 30 billion pounds, who added to his Portuguese bond holdings last week.

BUYING ON DIPS

Although worries over the health of European banks are nothing new, they have become more relevant now that a 12-month rally in the periphery has left assets in markets such as Portugal or Italy looking expensive.

Portuguese bonds have underperformed most of their euro zone peers over the past month, with 10-year yields at 3.87 percent trading around 40 basis points above nine-year lows hit in June. They nevertheless remain among the top performers for 2014 as a whole.

Portuguese 10-year bonds offer the second highest yield on euro zone sovereign debt after Greece, however, and pay a hefty pick up compared with dwindling returns on top-rated paper.

The ECB's new round of cheap four-year loans to banks, to be disbursed in September and December, is helping fuel demand for peripheral debt, so that any price dip is a buying opportunity.

"We are on a risk-on mode. It's no time to take the money off the table," said Didier Duret, chief investment officer at ABN-Amro in Geneva, which manages 165 billion euros and is positive on Spanish and Italian equities.

"Many clients are still weighted with cash: there will be people buying back in corrections."

Investors are encouraged too by the fact that Lisbon, which emerged from an international bailout in May, has built up a cash buffer after a series of bond sales this year and has already met two-thirds of its 2015 funding needs. Its recovery from a three-year recession is widely seen on course.

Exchange-traded products benchmarked on Portugal's PSI 20 <.PSI20> index have seen their assets under management jump by 50 percent since the start of the year after inflows of just over $50 million(29.17 million pound). So far in July, these ETPs have seen $2.9 million of inflows, according to data provider Markit.

"We believe the Portuguese economy has improved since the depths of the crisis and supportive policies from the ECB should allow this improvement to continue," said Threadneedle's Harvey.

(Reporting By Francesco Canepa and Emelia Sithole-Matarise; Editing by Lionel Laurent and Catherine Evans)

By Francesco Canepa and Emelia Sithole-Matarise