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 penalise some savers.
Cyprus's government proposed earlier to spare small investors from a tax on bank deposits in a last-minute attempt to win parliamentary backing for the rescue, but lawmakers still seem likely to reject the levy, a government spokesman said.
That would move the country closer to default and a banking collapse.
"The risk of contagion remains. (The move) weakens these same (bank deposit) guarantees throughout the euro zone," Richard McGuire, rate strategist at Rabobank, said.
"Even if it doesn't spark wider market tensions now, once these begin to return, this episode will act as an accelerant of crisis tensions and will raise the risk they have a more self-fulfilling effect."
German Bunds were up 29 ticks on the day at 144.23, after the future saw its biggest one-day gain since Feb. 26 on Monday.
Risk aversion also provided a favourable backdrop for a sale of Dutch paper, in which the Netherlands raised 6.52 billion euros of a new 10-year bond.
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.
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 and Italian bonds which have particularly benefited from the backstop were little changed on the day. 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 plan) 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," said Michael Leister, rate strategist at Commerzbank.
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 final outcome of the Cyprus saga, 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.
"We are just waiting for another headline out of Cyprus," one trader said, adding that buying Bunds "is the only trade to have on."