Rumours of EMU hold-ups give bonds the jitters

Spanish and Italian bonds tumbled out of bed late last week, clearly rattled by alarming talk that Germany was planning to delay the start date for the proposed single European currency.

German officials dismissed the speculation. Investors didn't. They lopped more than two points off Spanish bonds and more than 1.5 points off Italian bonds - the worst one-day drop in Italian short- term bonds in two years.

Even German bunds and UK gilts slid on the report, which is expected to sour sentiment next week as well. That's bad news for most bond investors - but not all.

Some investors who made a bundle last year betting that the planned single currency will start on schedule have been quietly making a new bet this year: buying bonds that pay off if it doesn't.

Merrill Lynch Internat- ional and Deutsche Morgan Grenfell are selling bonds that pay investors more if there's still a gap between money-market rates for German marks and other European currencies after 1999, the start date for European Monetary Union. The greater the gap, the more they pay.

Here's how the bonds work. When the single currency is introduced in 1999, the gaps between money-market interest rates in countries moving to full monetary union should - theoretically at least - disappear.

Confidence that this will happen helped drive bond yields lower in many markets last year, sending bond prices soaring and permitting investors to pocket big profits.

The new specially structured bonds, however, will pay more interest if those money-market gaps don't disappear because of roadblocks - or detours - on the road to the single currency.

And they're proving particularly popular with "German-speaking investors" according to Stefan Becker, the vice president at Merrill Lynch in Frankfurt, who created the bonds.

Last week, bond markets were rattled by speculation that Germany is plotting to delay the start date for the single currency.

"The assumption is not so much on EMU going wrong, but on it potentially being delayed or there being turmoil before we get there," Mr Becker said.

The two bonds aren't identical. The $100m German marks in bonds issued by Merrill will make a one-off interest payment when they're repaid on 25 February, 1999. Investors will receive seven times whatever the gap is between the two-year Ecu and deutschmark swap rates on 15 February, 1999. For instance, if the gap, currently at 0.75 per cent, doesn't change, investors will enjoy a return of 5.25 per cent.

Deutsche's bond, a 200 billion lire issue repayable in 2002, pays an initial coupon of 8 per cent. From September, however, the interest rate depends on the gap between six-month Italian and German interest rates. The bigger the gap, the more interest the bonds will pay.

Of course, many investors could place a similar bet without buying the new bonds by simply taking a position in the swaps or interest-rate futures markets. That way, they could also unwind the trade easily if it looked like monetary union might take place on schedule.

By building the structure within a bond, however, Merrill Lynch and Deutsche Morgan Grenfell are catering to funds barred from using derivatives or swaps.

"They're probably interesting for a fund with very tight restrictions," said Gerd Neitzel, a portfolio manager at Siemens AG in Frankfurt, which manages DM25bn of funds worldwide.

"But for a professional investor who wants to maintain the ability to control his risk, probably not." Copyright: IOS & Bloomberg.