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* Demand falls at Italian debt auction
* Cyprus concerns push Bunds to 3-week highs
* Analysts expect Italian bonds to recover
By Marius Zaharia
LONDON, March 27 (Reuters) - Italian bond yields rose on Wednesday as the stalemate over the formation of a new government and concern about the potential fallout from the Cyprus crisis hurt demand at an Italian debt auction.
Cyprus, fearing a run on its banks after agreeing to a rescue deal that will wipe out some senior bank bondholders and impose losses on large depositors, is expected to finalise a set of capital controls on Wednesday - the first time such measures have been used in the euro zone.
Investors are worried that depositors at banks in other countries may believe their savings are in danger, too.
There is also concern that the deal Cyprus agreed to in order to avoid potentially being forced out of the euro zone may become a template for solving other crises in the region - despite reassurance from policymakers that it will not.
Italy, which is still searching for a government after February elections that produced a hung parliament, sold 6.9 billion euros worth of five- and 10-year bonds, close to the upper limit of its 5-7 billion target range.
Demand was weaker than at previous auctions, however. The 10-year bond drew bids worth 1.33 times the amount allocated versus an average of 1.48 times so far this year. The bid/cover ratio for the five-year bond was 1.22 compared with a 2013 average of 1.4.
"Political uncertainties and market fears of another leg of recession in the euro area, due to risks of a break-up of the monetary union explain the weakness of the auction," said Annalisa Piazza, market economist at Newedge.
"The risks for Italian debt remain very high in the coming weeks."
In secondary markets, Italian 10-year yields rose 13 basis points to 4.72 percent, with the paper underperforming all other investment grade bonds in the euro zone. Equivalent Spanish yields rose 10 bps to 5.06 percent.
Italian yields were expected to rise further, although any increase would likely be met by renewed buying interest from investors who believe the European Central Bank's so far untested bond buying programme (OMT) is a powerful backstop.
"We expect that dips will be bought overall given that the OMT is in place and we have an ECB meeting next week where the market may be looking for some verbal confirmation of the ECB's resolve," said Michael Leister, rate strategist at Commerzbank.
Investors were closely watching centre-left leader Pier-Luigi Bersani's attempts to form a government. Ex-comic Beppe Grillo's anti-establishment 5-Star Movement on Wednesday flatly rejected overtures from Bersani.
Markets expect either a grand coalition to include the centre-right led by former premier Silvio Berlusconi or fresh elections in coming months. Neither option is particularly positive for Italian bonds, though.
ž"Although Bersani's consultations with other political leaders might lead to a grand-coalition government, markets are aware that such a government will not last long," Newedge's Piazza said.
"A set of reforms might be approved by the new government but we still expect Italy to go to another election before the end of the year."
Bund futures, which investors tend to grab in times of increased tension, were 64 ticks higher on the day at 145.46, having hit 145.52 earlier in the session - their highest since March 4.