EURO GOVT-Italian bonds steady, poll result to spark volatility
* Italian bond yields inch lower before election result
* Exit polls due at 1400 GMT, seen triggering volatility
* Scope for Italian/German spreads to tighten on Bersani win
LONDON, Feb 25 (Reuters) - Demand for Italian bonds held firm on Monday as the country's most unpredictable election in years drew to a close, with analysts expecting prices to become volatile once exit polls emerged later in the day.
An auction of Italian inflation-linked and zero-coupon debt drew solid demand, while bond yields dipped and the country's stock index rose -- moves consistent with lack of investor concern at the expected outcome.
"The Italy linker auction went reasonably well, which is part and parcel of the bigger picture which is that there appears to be limited market concern on the political front," said London-based Rabobank strategist Richard McGuire.
Exit polls due around 1400 GMT will be seized upon by markets looking to gauge whether the investor confidence in Italy, which grew under outgoing technocrat prime minister Mario Monti, will be maintained under a centre-left coalition, or whether a strong protest vote could produce an unworkable fragmented government.
Italian 10-year yields were 4 basis points lower at 4.41 percent while the safe-haven German Bund future dropped from a one-month high hit on Friday to stand 16 ticks lower at 143.46.
Traders said market activity was low, but the wide range of outcomes still possible meant volatility was likely to follow the first data showing how the Italian electorate voted.
"We're sitting here waiting for Italian news. The question is how much of the protest vote has there been ... you can argue the more of it that there is, the more likely there's going to be split houses or weak coalitions," a trader said.
Opinion polls give the centre-left coalition led by the veteran former industry minister Pier Luigi Bersani a narrow lead but the race has been thrown open by the prospect of a huge protest vote against austerity policies and rage at a wave of corporate and political scandals.
A win for Bersani's coalition could trigger a 50 to 75 basis point tightening between Italian and German yields according to a Goldman Sachs model that gives a "fair value" for Italian debt based on economic fundamentals.
The Italian/German 10-year yield spread was last at 284 basis points, around 5 basis points tighter on the day.
A less conclusive result, with no clear winner, was expected to see Italian debt underperform German bonds on the grounds that any eventual government formed could be unstable and less committed to the economic reforms markets believe necessary.
A third scenario, in which former Prime Minister Silvio Berlusconi, who left office in 2011 with Italy on the brink of a full-blown funding crisis, wins influence was seen as the least likely outcome, but the most damaging for Italian debt.
"The outlook for Italian fiscal policy and reforms as well as for further European fiscal integration would be markedly blurred," Commerzbank strategists said in a note.
"This would most likely trigger a massive risk-off shift with Bund set to test new lows for the year below 1.45 percent."
Ten-year Bund yields were last at 1.58 percent, up 1 basis point on the day.
(Editing by Nigel Stephenson)