Aug. 7 (Bloomberg) -- Investor demand for emerging-market bonds is driving the cost of insuring against debt defaults below industrialized governments for the first time.

Credit-default swap prices from Turkey to Indonesia are falling as bonds rise amid signs that their economies are recovering faster than developed nations. As the U.S. and U.K. borrow record amounts to fund bank bailouts and stimulus, Brazil, Russia, India and China have $3 trillion in reserves, up 19 percent from January 2008 and now 43 percent of the worldwide total, data compiled by Bloomberg show.

The annual cost of protecting holdings in Turkey’s bonds fell by half to $200,000 per $10 million for five years, or 200 basis points, sinking below New York City swaps for two weeks starting July 22, Bloomberg data show. Indonesia debt insurance dropped below Michigan the next day. Brazil swaps just had their biggest four-month slide ever. For China, protection is near the cheapest in a year. Eleven years after Russia defaulted, investors want less to insure its debt than California’s.

“This would have been impossible to imagine a year ago,” said Dmitry Sentchoukov, an emerging-market credit strategist at Dresdner Kleinwort in London. “Now it’s clear emerging economies are going to outperform the Group of Seven in growth, and that makes investors comfortable with the idea that developing countries can be priced richer than developed.”

Speculation

Swaps pay the buyer the amount protected in exchange for the defaulted debt’s market value or the bond itself if the borrower reneges. Created to protect lenders, the contracts also are used by hedge funds and insurance companies that don’t hold the underlying bonds to speculate on swings in the market’s perception of debtors’ creditworthiness.

The average cost of swaps for sovereign debt from 45 developing countries has declined to 314 basis points, the lowest since October, from 785 basis points five months ago, data compiled by Bloomberg show. Emerging-market bond funds held almost $49 billion on July 31, the most since October, after their biggest weekly cash influx in a year. They’ve attracted more deposits than withdrawals every week since April 13, following eight months of declines, said EPFR Global, a Cambridge, Massachusetts, researcher.

“CDS spreads have come in because there are a lot less worries about default,” said Paul McNamara, who invests in swaps while overseeing $2 billion in emerging-market debt at Augustus Asset Managers in London. His funds have received $500 million in new investments this year, he said in a phone interview.

Softer Downturn

Increased government and consumer spending are mitigating the economic downturn in emerging markets amid the worst global recession since World War II.

Manufacturing in China expanded in July to the highest in a year, spurred by a $585 billion government stimulus package and a record $1 trillion of new bank loans in the first half. The country’s 4.25 percent bonds due 2013 rose to a one-year high of 105 cents on the dollar last month from October’s record low 97 cents. China swaps cost 66 basis points, down from 297 on Oct. 24. That’s cheaper than Greece and Ireland and within 9 points of Austria, Italy and Spain.

Consumer spending in Indonesia accounts for about two- thirds of the economy, which expanded 4.4 percent in the first quarter, the fastest pace in Southeast Asia. Indonesia’s 2014 dollar bonds sold in March climbed to a record 121.5 cents on Aug 4. Default swaps on the country’s debt fell below 200 basis points for the first time since January 2008 this week, dropping to 197 on Aug. 3. They were at 207 basis points yesterday.

IMF Predictions

Emerging economies probably will expand 1.5 percent this year and 4.7 percent in 2010, the International Monetary Fund forecast July 8. Developed economies likely will shrink 3.8 percent in 2009 and grow 0.6 percent next year, the IMF said. The U.S. is in its worst downturn since the 1930s with consumer spending, 70 percent of gross domestic product, dropping at a 1.2 percent pace in the second quarter.

Developing economies have been able to draw on reserves accumulated before the credit crunch started in 2007 to shield their economies. Russia spent about $49 billion from its Reserve Fund as of July 31 and will empty the stockpile by the end of 2010 to plug an estimated budget shortfall equivalent to as much as 9.4 percent of GDP, according to the government. Turkey, the world’s 17th largest economy, has $67 billion in foreign reserves, more than the U.S.’s $41.9 billion, Bloomberg data show.

California’s IOUs

In the West, governments are selling debt to fill budget gaps and fund bank bailouts. California has sold nearly $14 billion of general obligation bonds this year, up from $8.18 billion during all of 2008. The most populous U.S. state cut spending, raised taxes and issued IOUs as it battled with $60 billion in deficits over the past two fiscal years.

Swaps on California have risen more than three-fold in the past year as its credit rating was lowered two levels to Baa1 by Moody’s, the same level as Russia, which reneged on $40 billion of sovereign debt payments in 1998. Russian default swaps are near a 10-month low of 255 basis points, about 20 basis points less than contracts linked to California. The former Soviet state’s 7.5 percent, 2030 dollar bonds are at a 2 1/2-month high of 101.74 cents on the dollar.

“If California is issuing their own dummy currency in the form of IOUs, that’s not a good sign,” said Augustus’ McNamara.

Russia has an “extremely low” debt-to-GDP ratio of about 10 percent which is attractive to “any type of bond investor,” said Luis Costa, an emerging-market debt analyst at Commerzbank in London. “For as long as U.S. municipal and state governments are in trouble, I think this trend will continue.”

Increased Borrowing

By comparison, the U.S.’s $11.2 trillion of debt is about 79 percent of its $14.1 trillion in GDP, Bloomberg data show.

Issuance of Treasuries by the U.S., which has spent more than $300 billion to prop up its banks, may total $446 billion this quarter, up 30 percent from the prior three months, according to a Securities Industry and Financial Markets Association survey published July 30.

The extra yield investors demand to own developing country bonds over similar-maturity U.S. Treasuries dropped to near a one-year low of 3.41 percentage points this week, from 6.95 in March, JPMorgan Chase & Co. indexes show.

“This trend of lower sovereign spreads will continue,” said Richard House, who manages $1.1 billion in emerging-market debt at Threadneedle Asset Management in London. “Balance sheets are so strong now and most governments don’t need to sell debt in the external markets.”

Yield Spreads

Even as investors buy up developing economies’ debt, the countries still pay more to borrow on international markets. Investors on average demand an extra 112 basis points in yield over Treasuries to own China’s debt, two basis points less than Ireland’s 1.10 percentage-point spread, Merrill Lynch & Co. Inc. indexes show.

Credit-default swaps on China cost less than half the 143 basis points for Ireland, which contracted a record annual 8.5 percent in the first quarter as the bursting of a decade-long property boom drove unemployment to a 13-year high, forced the government to raise taxes and cut spending and left banks nursing billions of euros in souring loans.

The cost of protecting against a default by Turkey plunged below New York City’s for two weeks before climbing back above yesterday. The country is negotiating a new IMF loan accord to add to the equivalent of about $49 billion in assistance it has received since 1984. Turkey increased its 2009 budget deficit forecast to $33 billion in April. The government is attempting to end a 25-year conflict with Kurdish rebels that has cost almost 40,000 lives and spread into neighboring Iraq.

Stocks Rally

Swaps for New York increased more than three-fold in the past year. The world’s financial capital, rated nine levels higher than Turkey by Moody’s Investor’s Service at Aa3, faces unemployment close to 10 percent and reduced tax revenue from Wall Street firms. New York City Mayor Michael Bloomberg is founder and majority owner of Bloomberg News parent Bloomberg LP.

As emerging-market bonds rally and swaps plummet, stocks from those economies are leading a climb in global equities. The MSCI Emerging Market Index has added 51 percent this year, compared to a 15 percent increase in the MSCI World Index of developed stocks.

McNamara of Augustus Asset Management said he has reduced his investments in credit-default swaps this year because they are less liquid than bonds and have higher capital requirements and regulatory risks.

“They have lost their competitive advantage to bonds,” he said.

To contact the reporter on this story: Laura Cochrane in London at lcochrane3@bloomberg.net

Last Updated: August 7, 2009 08:14 EDT http://www.bloomberg.com/apps/news?pid=2....