EURO GOVT-Cyprus deposit grab spooks investors, hurts Spanish, Italian debt
* Spanish and Italian yields rise after surprise Cyprus deal
* Cypriot deposit tax sets worrying precedent for periphery
* No widespread panic, many awaiting vote on bailout plan
By William James and Marius Zaharia
LONDON, March 18 (Reuters) - Spanish and Italian bond yields rose on Monday after Cyprus caught investors off guard with a bailout deal partially funded by a tax on banks' savers that some feared could set a euro zone precedent.
The value of Cypriot bonds fell sharply while increased demand for German debt, seen as least risky in the euro zone, pushed 10-year Bund yields to their lowest levels this year.
Cypriot ministers scrambled to revise the bailout terms, but after the weekend announcement that part of a 10 billion euro ($13 billion) bailout would be paid for by imposing a tax on bank deposits, investors were keen to sell risky, higher-yielding bonds.
"Investors are now really sensitive to policy risks. Euro zone policymakers have really shown that they're not afraid to break any taboos," said Commerzbank strategist Michael Leister.
The decision marked a radical shift by international lenders who have previously bailed out Greece, Portugal and Ireland without making savers pay.
Brussels has emphasised that the measure is a one-off for a country that accounts for just 0.2 percent of European output.
But, although there was no widespread panic, the plan raised fears that a scramble to withdraw cash could spread to larger states still seen as possible bailout candidates, such as Spain and Italy.
Spanish 10-year yields rose 8 basis points to 5.01 percent while the Italian equivalent was up 6 bps at 4.67 percent.
Neither move took bond yields out of their recent ranges and traders reported some opportunistic buyers taking advantage of the rise to add to their positions.
But dealer said many longer-term investors were waiting before deciding their strategy.
"The level of inactivity from the underlying client base is quite frightening - whether that's because they don't have any positions or they don't know what to do," a trader said.
"The key to this is whether we see any cross-border contamination - if we see deposits flowing out of Spanish or Italian banks then things could step up quite quickly."
German Bund futures rose 57 ticks to 143.96 and 10-year yields dropped to a 2013 low of 1.37 percent.
Government sources said Cyprus's banks will remain closed until Thursday pending a vote by the country's 56-member parliament on the plan on Tuesday. Approval is far from a given: no party has an absolute majority and three parties have said outright they will not back the tax.
The uncertainty was felt in the island's illiquid bond market, as the price of its June 2013 issue fell three cents in the euro. The cost of insuring against a default also rose on the chance that a rejection of the bailout deal leaves Cyprus unable to repay the 1.4 billion euro June bond.
Offsetting the risk of contagion from Cyprus, some pointed to the European Central Bank's long-standing promise to step in and buy bonds if necessary as an effective limit to the spread of investor jitters.
That made any widening in the spread between Italian and German bond yields a buying opportunity said ING rate strategist Alessandro Giansanti. The spread could widen to 370 bps in the near-term from 325 bps currently, but that would be a good level to buy Italian bonds again, he said.
"The impact may be more or less short-lived. Cyprus is an isolated event, I don't see haircuts in deposits in bigger countries," Giansanti said.
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