EURO GOVT-Safety sought in Bunds before Cyprus vote on bank levy
* Bunds rise on Cypriot uncertainty
* Cyprus set to vote on controversial deposit levy
* Market reaction has been contained, contagion risk remains
LONDON, March 19 (Reuters) - Uncertainty that Cyprus can avoid a default underpinned safe-haven Bunds on Tuesday, with lawmakers due to vote later on a controversial law that would secure the country a bailout but penalize ordinary savers.
A government official said parliament is likely to reject a levy on bank deposits, even as Cypriot and euro zone officials sought to soften an initial proposal that many investors say sets a dangerous precedent for the euro zone.
"We are just waiting for another headline out of Cyprus," said one trader, adding that buying Bunds "is the only trade to have on."
German Bunds were up 27 ticks on the day at 144.21, after the future saw its biggest one-day gain since February 26 on Monday.
"It's quite serious, it's got bigger implications. I think there is (a risk) of some cross border contamination," the trader said.
The proposal for a one-off charge on bank accounts held in Cyprus unsettled financial markets on Monday, reflecting worries it could spark bank runs in other struggling euro zone states and revive the bloc's debt crisis.
Cypriot banks are closed until Thursday but widespread cash withdrawals are feared once they reopen.
Rejecting the levy, which is a condition of the rescue package agreed at the weekend, would move Cyprus nearer to a default on its debts and a banking collapse.
Overall market reaction to news of the proposed levy on savers has been relatively muted, with some analysts saying the market remains insulated by the European Central Bank's as-yet untested bond-buying promise.
Spanish 10-year yields were flat at 5.0 percent, while their Italian equivalents were 3 bps higher at 4.66 percent.
"The OMT (Outright Monetary Transaction) is still in place ... so the backstop is still there. A taboo has been broken which is a clear negative, but Cyprus is a special case," Michael Leister, rate strategist at Commerzbank said.
He expected the vote in Cyprus to pass but with an adjustment to the legislation to better protect small deposit-holders. However, he still favoured German Bunds.
"For now we stick to safety, in peripherals, (we) take a neutral stance, with overweights in Ireland and Portugal."
Whatever the outcome, analysts said the mere consideration of making savers pay for bailouts sets an unsettling precedent for the euro zone, because deposit-holders could think their savings could be compromised at any point.
"My view is that the contagion risk could be very real if there is a re-escalation of the European sovereign crisis, so it might be more of a medium-term risk than an immediate one," Gary Jenkins director of Swordfish Research said in a note.
The Netherlands will sell 5 billion euros of 10-year bonds later this session.