* Bunds fall ahead of ECB, Greek debt swap * Italian, Spanish yields fall on better risk tone * ECB set to hold rates at 1 percent By Kirsten Donovan LONDON, March 8 (Reuters) - German government bonds fell on Thursday on optimism Greece would gain enough creditor support to restructure its debt and avoid a messy default but losses were contained with Athens' finances still seen as unsustainble. Trading was relatively light, however, before the deadline for investors to say whether they will participate in the Greek debt swap and a European Central Bank policy meeting which is set to leave rates on hold at 1 percent. Major banks and pension funds said on Wednesday they would take up the Greek offer, making it increasingly likely the deal would pass. But while a deal may bring some short-term relief to markets, their focus was already shifting: to Portugal, seen as the next most likely to restructure its debt; to Spain, which has relaxed its deficit targets; and to looming elections in Greece and France, as well as persistent fears Greece may need yet more help. "It looks quite ambitious to see Bunds rising further but I see no reason for a turnaround in the near future," said Christoph Kind, head of asset allocation at Frankfurt Trust, which manages assets worth 16 billion euros. "If you look at fundamentals there are good reasons why interest rates do not rise. Growth is weak, inflation is not really picking up and monetary policy is extremely loose. So why should yields rise?" June Bund futures were 27 ticks lower at 138.29. The March contract, which expires on Thursday marked record highs on Wednesday of 140.52. "Despite the rally in the periphery, Bunds still seem incredibly well supported and the Greek deal being done is really in the price already," a trader said. "Bunds are really a liquidity play now rather than an economic play." Ten-year German yields were 2.5 basis points higher at 1.81 percent but still close to the lower end of this year's trading range. "Any post-PSI relief rally in risk assets is likely to be short-lived...not least owing to the possibly rapid realisation that Greek debt is unsustainable even in the wake of this restructuring, which we see as but the first attempt," Rabobank rate strategists said in a note. The ECB is expected to signal it has played its part in fighting the euro zone crisis after pumping more than 1 trillion euros into the banking system since the end of December, action which has had the knock-on effect of lowering yields on bonds issued by Italy and Spain, in particular. Italian 10-year government bond yields were down 14 bps at 4.81 percent, with the Spanish equivalent 6.5 bps lower at 5.05 percent. Italian bonds have outperformed Spanish paper consistently this month after Spain revised its 2012 budget deficit target to 5.8 percent of gross national product from 4.4 percent. "The concerns about Spain's problems with respect to its budget deficit are near term more pressing than the high debt-to-GDP figure in Italy and we can still see further outperformance of Italy versus Spain in the near term," said Norbert Aul, rate strategist at RBC Capital Markets. "However, a flat spread level should actually be a fair representation of the credit for those two countries," he added, noting that the impact of the ECB's liquidity provision had been equally positive for both countries while any failure to carry out reforms in either country would pose an equal risk to the euro zone as a whole. The trader said that many investors who track an index of euro zone government bonds had moved from underweight positions on Italian bonds but there were more reservations about Spain. "We saw a big bit of reweighting of Italy a little while back, but the markets which are still underweight, where there not really a hurry to jump back in, are Spain and France, Spain because of concerns over the regions and France with elections coming up," he said.

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