German bonds, cast aside by investors last year in favour of higher- yielding Spanish and Italian bonds, appear to be coming back in fashion in 1997.

So far this year, 10-year bund yields have fallen by almost half a percentage point amid growing confidence that inflation represents little threat to the German economy. From a peak of 6.58 per cent last year, German borrowing costs have fallen by more than 1 per cent.

But even these near-record-low yields, and steep prices, aren't keeping bond buyers away, for at least two reasons.

First, yields are falling in other bond markets; second, concerns are once again growing about the proposed single European currency.

"Everywhere you look, bond markets are breaking historic lows, so it's logical that German bond yields are looking more attractive," said Rainer Back, chief fixed-income analyst at Dresdner Kleinwort Benson.

Mr Back predicts bund prices will continue to rise in the coming months, sending yields as low as 5 per cent, as the key deadline for the single currency approaches.

Would-be members of the monetary union have just 12 months to get their economies into shape and meet rules on inflation, long-term interest rates and exchange rates, as well as limits on budget deficits and public debt.

In 1996, confidence that many governments would make an effort to join a common currency encouraged investors to pour money into so-called "convergence trades", buying Spanish and Italian bonds in the belief that their inflation rates would fall to levels seen in Germany.

Those trades pared the yield premiums these peripheral bonds offered over German bunds. A year ago, an investor buying Italian rather than German 10-year bonds receieved 470 extra basis points of yield. Today, investors get just 170 basis points more. Six months ago, the Spanish 10-year bond gave investors 262 basis points more in yield. Today, investors get just 111 basis points more.

The trend, however, may have run its course. "You've pretty much had your lot as far as convergence is concerned," said Stephanie Mason, who manages $3bn (pounds 1.9bn) at WorldInvest. "More and more people seem to have very high holdings of German bonds."

Much of the doubt surrounds Italy, where there's concern that the coalition government is too divided to deliver compliance with the single currency requirements. Doubts like that lure investors back to Germany, the European country with the best post-war record of fighting inflation.

"At the moment, Germany looks very interesting to me," said Werner Blum, who manages DM10bn (pounds 3.7bn) at DWS Deutsche Gesellschaft. "Depending on which way the EMU discussion goes, we could well see another flight into German marks." Copyright: IOS & Bloomberg