The rally in eurozone bonds has a surprising star: Portugal.

Investors have been rushing into eurozone debt of late, lured by a mix of buoyant economic data and relaxation of political risk. And Portugal, among the EU's smallest members and one that suffered through a bruising bailout six years ago, has benefited from the flood of capital flowing to Europe's periphery.

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Yields on Portuguese 10-year debt closed at 3.092% Tuesday, at eight-month lows. That is a sharp reversal from the 4.3% reached in February, when borrowing costs rose on fears the French would elect anti-European Union candidate Marine Le Pen as president. Instead, the April 23 victory of Emmanuel Macron in the first round of the election sparked a relief rally across Europe.

Money flowing into Portuguese equity funds has rocketed since, figures by EPFR Global show, much more than elsewhere in the eurozone. Portuguese 10-year yields have also led the fall and dropped 0.7 percentage points, compared with 0.1 percentage points for Italian yields. Only Greek yields have fallen more, but for a different reason -- expectations that international creditors will eventually unlock new bailout funds.

Bond investors have been further cheered by data showing that the three-year economic recovery in Portugal, where 10-year borrowing costs rose above 16% at the height of the sovereign debt crisis in 2012, is accelerating. Portugal's economy expanded by an estimated 2.8% year-over-year in the first quarter, the fastest pace in nearly a decade. Annual growth is expected to continue but ease to an average of about 1% to 1.5% in the medium term, according to Moody's Investors Service.

"The facts would suggest you are past the point of greatest grief," says Steven Andrew, a fund manager at M&G Investments, a GBP265 billion ($345 billion) asset manager, who was long cautious about Portugal but turned into an enthusiastic buyer earlier this year.

Portugal remains, however, one of Europe's weakest links. Only credit-rating firm DBRS Ltd. considers the country's debt to be investment grade. Without at least one investment-grade rating, Portugal would lose access to the European Central Bank's bond-buying program. Moody's and the two other major credit-rating firms each rate Portugal's debt in junk territory because of the country's high government debt and weak banking sector.

Despite the hurdles to a deeper economic recovery, business owners such as shoe designer Luis Onofre say they are feeling the nascent optimism in Portugal. The country's bailout years were "a dark period," Mr. Onofre said, but "the clouds have gone away."

Visitors have poured into Portugal, fearful of terrorist attacks in France, Turkey and Egypt. Tourism now makes up 6.4% of GDP, the highest on record and far above the 4.6% level reached in 2011, according to data by the World Travel & Tourism Council.

That has given Mr. Onofre, 46 years old, the confidence to open a store that bears his name in Porto, a city famous for its sweet wine. An existing shop on Lisbon's main fashion strip, Avenida da Liberdade, where he sells high-end men and women's shoes made in two factories in Portugal, is thriving.

Portugal isn't the only one benefiting from the rush to peripheral bonds amid a sense that Europe is putting years of economic and political turmoil behind it. Spain, among Europe's fastest-growing major economies, has become a poster child for the eurozone recovery.

Portugal hasn't been long on optimism in recent years. A debt bubble and rampant public spending -- Portugal's budget deficit was nearly 10% of GDP in 2010 -- forced the country to take a EUR78 billion international rescue package in 2011. It is recovering from the double-dip recession that followed the bailout.

"It has taken a decade, almost a decade, to correct the mistakes of a past decade," Carlos Moedas, European commissioner for research, science and innovation and a former Portuguese minister, said.

Now, its budget deficit is down to 2% of GDP, while business and consumer optimism is at levels last reached in 2001. A coalition between the Socialists and other leftist parties including Communists -- an alliance so unlikely that it was dubbed "geringonça," or "contraption" when it was formed in late 2015 -- has governed well, business executives and investors say.

Real-estate prices in cities such as Lisbon and Porto are on the rise. This week, Portugal requested EU permission to repay ahead of schedule about EUR10 billion in bailout funds to the International Monetary Fund.

But doubts remain about whether the country has made enough structural changes to ensure a deep and durable recovery -- a reminder that the Europe's peripheral economies remain vulnerable.

Portugal's debt-to-GDP ratio is the highest in the EU after Greece and Italy and will likely remain above 125% in the coming years. And unlike in neighboring Spain, Portugal didn't do a deep clean of its banking system. Bad loans make up 17% of total lending, which is crimping the flow of fresh loans. That has in turn stalled investment.

"You see all this bullishness around you," said Nuno Vilaça, partner at advisory investment boutique Raven Capital in Lisbon. But, he added, "there is a long way to go in the financial sector and in the industrial sector."

Like other areas of the periphery, such weaknesses leave Portugal particularly vulnerable when the European Central Bank pulls back on its extremely loose monetary policy, which investors expect to happen next year. Portuguese paper could come under more pressure if the central bank slows its monthly purchases of bonds, said Patrick O'Donnell, senior investment manager at Aberdeen Asset Management, which oversees more than GBP308 billion ($395 billion).

"Small markets are much more dependent" on the ECB, he added.

Write to Jeannette Neumann at jeannette.neumann@wsj.com and Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

May 31, 2017 05:44 ET (09:44 GMT)