* ECB safety net seen keeping Cyprus contagion in check * Cyprus scrambles to avert funding crisis * German Bunds underpinned as EU deadline for Cyprus nears By Emelia Sithole-Matarise LONDON, March 22 Spanish and Italian bonds rallied on Friday after Cyprus said it had reached a deal to spin off the Greek units of its debt-ridden banks as part of efforts to contain its funding crisis. The Mediterranean island said the Greek deal was favourable to Cyprus, which is facing a Monday deadline to raise the 5.8 billion euros needed to secure a 10 billion euro international lifeline or face the collapse of its financial system. Spanish 10-year bond yields were last 16 basis points down on the day at 4.835 percent, outperforming equivalent Italian ones which were 12 bps lower at 4.52 percent . "We still think that the base case is that they'll find a solution in the end and find this 5.8 billion that's missing for the bailout. We still see a lower probability of a worst case outcome," said Alessandro Giansanti, a rate strategist at ING. Spanish and Italian yields have reversed this week's rise triggered after a European Union proposal - rejected by Cypriot lawmakers - to impose a levy on bank deposits to raise funds needed to secure an international bailout. BAD NEWS FATIGUE Demand for bonds issued by the euro zone's troubled third and fourth largest economies has been resilient in the face of Cyprus's debt problems on investor conviction that the European Central Bank will step in with bond-buying support. "The market has absorbed quite a bit of bad news recently and it takes increasingly even worse news to shake up some of these peripheral spreads," said Citi strategist Peter Goves. "You've still got the ECB saying it will be providing liquidity needed and the OMT (ECB bond-buying plan) is still there waiting in the wings and you've got authorities stressing this is a special case. That probably goes some way to explain some of the market dynamics." Although many in the market expect a last-minute solution to stop Cyprus from becoming the first euro zone state to quit the currency bloc, the uncertainty is feeding demand for safe-haven German debt going into the weekend, pinning 10-year yields near 2013 lows of 1.34 percent. Talks in Moscow on a funding lifeline from Russia also ended without result. German 10-year yields were last 1.5 basis points down at 1.36 percent while the 30-year bond yield was 3 bps lower at 2.23 percent, around its lowest since late December. "They (EU) are pushing for a solution to come over the weekend but we still have the risk that the situation can get out of control especially in terms of the banking sector. That's why we have pressure for lower core yields," said Giansanti. Bund futures were last 3 ticks up on the day at 144.49, retreating from a session high of 144.83 after news of the Cypriot-Greek bank deal. Trade in Bunds, perceived as a safe haven at times of market stress, was expected to remain volatile given doubts over Cyprus and Italy's struggle to form a government almost a month after its inconclusive elections. "Every headline moves the market at the moment so it's quite hard to trade. Going into the weekend people aren't going to go much short (on Bunds)," one trader said. "We're remaining constructive on Bunds. We still think 1.25 (percent in 10-year German yield) is a viable target for the market. The market is fairly well underpinned at the moment."