March 20, 2013 / 12:06 PM / 4 years ago

EURO GOVT-Bunds dip but Cyprus keeps investors on edge

* Risk appetite recovers, Bunds dip, but tension remains high

* German Bund auction yield at lowest since July 2012

* Spain, Italy rebound as some keep faith in ECB backstop

By William James

LONDON, March 20 (Reuters) - New uncertainty over Cyprus's future in the euro zone kept German Bund yields near their lowest levels of the year on Wednesday as the country scrambled to find a plan B to solve its debt problems.

A 36-0 parliamentary vote late on Tuesday against plans to partially fund a bailout for Cyprus with a deposit levy left policymakers desperately looking for another solution and kept investors in cautious mood.

While German Bund futures, sought as a safe haven in times of market stress, were 26 ticks lower on the day at 144.36, they remained at elevated levels and few expected prices to fall significantly in the near term.

Talks with Russia on restructuring an existing loan to Cyprus failed to reach an agreement on Wednesday and Russian officials have yet to decide on a request for an additional 5 billion euro loan. The Cypriot finance minister said he would stay in Moscow for as long as needed to secure a deal.

Underscoring the caution, a German 10-year bond sale found strong demand compared to similar sales this year and came at the lowest auction yield since July 2012 - a time when an investor exodus from the region's lower-rated states threatened the euro zone's future.

"The cheapening that we've seen this morning combined with the ongoing fear about Cyprus contributed to ... a good result despite yields trading close to the year's lows," said Michael Leister, a rate strategist at Commerzbank.

In the secondary market, 10-year German bond yields were 2 basis points higher on the day at 1.37 percent, but still 8 bps lower on the week and within sight of Tuesday's 2013 low of 1.34 percent

The precarious position of Cyprus's banks, which are heavily dependent on European Central Bank support, has increased the urgency of finding a new plan. Without a solution, Cyprus risks default as early as June, when a 1.4 billion euro bond matures.

Cypriot banks stayed shut on Wednesday and traders said many investors were waiting to see whether fears of a rush to withdraw money from the system would materialise. Any signs of a bank run would accelerate the sense of crisis and switch the focus to Italy and Spain for any signs of spillover.

PERIPHERY AT RISK

The chaos in Cyprus has already caused investors to back away from bonds issued by the region's other struggling countries, and upward pressure on Spanish and Italian bond yields was expected to remain high.

"The risk is that we see more serious contagion... we're sticking to our long Bunds, short periphery positions," a trader said, referring to bets that the yield gap between German and weaker bonds would widen.

Despite the expectation of more pressure, a rebound in equity markets and expectations that ECB safety measure would limit contagion helped keep Italian and Spanish yields in check.

The 10-year Italian yielded 4.67 percent, down 4 basis points on the day, while the Spanish equivalent yield was 2 bps down at 5.03 percent.

"On the long term I would say all the widening we have seen in Italy and Spain are opportunities to play for another spread compression," said BNP Paribas strategist Patrick Jacq.

"But, having said that, it's clear that the very near-term environment remains risky enough not to enter these kind of trades massively."

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