* Fear of sanctions is as bad as sanctions themselves
* Foreign holdings of rouble government debt down sharply
* Russia is worst performer this year in emerging bond index
* South Africa, Hungary and Turkey returning to favour
By Sujata Rao
LONDON, May 8 Emerging market investors are
dumping once-hot rouble bonds due to the threat of tougher
sanctions hanging over Russia, shifting funds to the likes of
South Africa, Hungary and Turkey which only recently had been
Seemingly conciliatory comments from President Vladimir
Putin on the Ukraine crisis have soothed markets this week. But
fears remain that the West - which has so far targeted only a
small number of Russian individuals and firms - will impose
harsher sanctions, including on the financial sector.
"The fear of sanctions is as bad as sanctions themselves.
The fear is: what could you do with Russian assets if sanctions
get ratcheted up?" said Kieran Curtis, a portfolio manager at
Standard Life Investments, who has gone overweight Turkish local
bonds at the expense of Russia.
Russian government bonds, one of the top emerging market
trades of 2012 and 2013, are feeling the heat far more than
equities, which have been out of favour for a long time.
Foreign funds held 22 percent of the locally-issued debt at
the beginning of March, sharply down from a peak of over 28
percent hit in mid-2013 after Moscow eased investors' access to
domestic bond markets.
This share almost certainly fell further in April due to the
hardening East-West standoff, with the United States and
European Union imposing sanctions after Russia annexed Crimea
from Ukraine in March.
Curtis has cut his rouble government bond holdings to below
their 10 percent weight in the most widely-used domestic debt
index, JPMorgan's GBI-EM, while the reverse is true for Turkey.
He is not alone. Quarterly data from Boston-based EPFR
Global shows that debt funds it tracks had an average 9 percent
allocation to Russia by the end of March, down from 10 percent
three months earlier and 11 percent last October.
That indicates funds have taken an underweight position
relative to Russia's share in the GBI-EM.
Overall Russian exposures fell to a new record underweight
in April, according to JPMorgan's monthly client survey which
also showed rouble exposure in April at the lowest since 2009.
Sanctions or not, Russia is the GBI-EM's worst performer
this year, having lost 11 percent in dollar terms while the
index gained 3.5 percent. Much of that is down to the rouble
which has fallen 6 percent this year against the dollar.
All this has spurred a hunt for alternatives, not all of
which have been popular with foreign investors of late. "It's a
bit of a struggle and you probably have to get comfortable with
something you may not have liked before," Curtis said.
He named Hungary, where some government policies have upset
foreign investors, and South Africa, which has suffered from
political uncertainty and labour unrest, as the other likely
destinations for cash coming out of Russia.
Money leaving Russia is also heading to other members of the
"Fragile Five", countries which have been out of favour because
of their high reliance on foreign capital for economic growth.
Most of the five - Turkey, Brazil, Indonesia, South Africa
and India - have taken steps to rein in their balance of
payments deficits since last year.
"The lucky thing from an investor perspective is that the
Fragile Five have shown big improvements and that's made people
feel comfortable opening positions in those countries with the
money they may have invested in Russia," Curtis said.
Bond auctions across these countries have attracted robust
demand in recent weeks whereas Russia has cancelled 10 of the 16
scheduled debt sales since the start of this year.
YIELD AND SIZE
Two issues confront investors looking to switch into other
markets - size and yield. Russia not only has a big weight in
the GBI-EM, it is also among the highest-yielding at over 9
percent, compared with the index average of 6.8 percent.
Domestic debt markets in some countries in eastern Europe
and east Asia are simply not large or liquid enough.
"If you need to exit Russia there are very few places to
hide, you can't go to Romania or Philippines. So people are
having to move into the big markets such as Turkey or South
Africa," said UBS strategist Manik Narain.
Brazil, South Africa and Turkey - each of which comprises a
tenth of the index - still offer annual yields of 8 percent or
more. Hungary yields 4.3 percent, but returns after hedging for
currency risk are among the highest in emerging markets.
Other big markets such as Poland, South Korea or Mexico are
less popular, because yields here are too low or positioning is
too crowded, Narain said, adding that many clients had switched
to South Africa after shunning it at the start of 2014.
"Data and the resilient rand show a recovery of foreign
inflows into South Africa which has one of the highest nominal
yields in emerging markets," he added.
Flows have been robust. Foreigners have bought more than 17
billion rand ($1.62 billion) worth of bonds since early March,
according to the Johannesburg stock exchange.
In Hungary, where the JPM survey showed record-high exposure
levels last month, almost 250 billion forints ($1.14 billion)
flowed into domestic bonds in March and April, according to the
state debt agency. Turkish bonds took in $1.5 billion last month
after suffering net outflows in March, central bank figures
Bond yields in these countries, unlike in Russia, have been
falling. Turkey - which suffered major political uncertainty
earlier this year - is down 200 basis points since early March
as eased, and South Africa has slipped 40 bps.
"We saw very sharp declines in Turkish yields in literally
two weeks or so. The anecdotal evidence is money is going there
from Russia," said Steve Ellis, a portfolio manager at Fidelity
Ellis is neutral on Russia, however, reckoning high yields
will force many investors to "close their eyes and stay in".
But seeking high Russian yields means shouldering the huge
risk of being exposed to a falling rouble.
Investors often hedge or protect themselves against currency
risk via derivatives but in Russia's case, political risks and a
200 bps rise in interest rates this year mean hedging costs are
prohibitive and would at one stroke wipe out the return.
In other countries such as South Africa, Mexico and Hungary
hedging is cheaper so it is possible to make a decent return.
These countries' steep yield curves - where longer-dated bonds
offer a large premium to short-dated ones - mean that net
returns can rise as the curve extends.
So a fund holding 10-year South African bonds can get a net
return of around 1.6 percent a year, Narain of UBS estimates,
while in Hungary and Mexico returns are 3.5 percent or more.
But investors are watching the Ukraine crisis closely. Any
easing in Putin's stance and a reduction in sanctions risk could
bring cash back into rouble debt.
"We would want to see moderation of geo-political risk,"
Fidelity's Ellis said. "But everything has a price ... 9.5
percent yield on the 2027 bond is attractive and if we see
another big selloff we may look at taking an overweight
(additional reporting by Sandor Peto in Budapest and Seda Sezer
in Istanbul; editing by David Stamp)