LONDON, Feb 27 (Reuters) - High-yielding dollar bonds from Venezuela, Argentina and Ukraine, once at the core of most emerging debt portfolios, are deep in the red, leaving investors scrambling for the returns they once provided.
Dubbed the Toxic Trio by one investor, the countries have seen sharply higher political tension, falling central bank reserves and a default probability of over 50 percent in the coming five years, as priced by debt insurance markets.
Together, the three account for a tenth of the EMBI Global index, used by 80 percent of emerging debt funds, or around $250 billion. They also comprise 2 percent, or $50-$80 billion, of corporate debt indices, Nomura analysts calculate.
But because the bonds offer juicy interest rates, the trio's share in portfolios often far exceeds this threshold.
If the average emerging sovereign bond yields a 3.5 percentage point premium over U.S. Treasuries - under 6.5 percent in absolute terms - some Toxic Trio bonds yield around 10 percentage points more than U.S. benchmarks.
Even so, the risks are becoming too hard to stomach.
"We are underweight the Toxic Trio," Kevin Daly, a portfolio manager at Aberdeen Asset Management, told an Emerging Markets Trade Association forum last week.
He is not alone. A monthly client survey by JPMorgan which runs the EMBIG index, showed funds running a record underweight position on Ukraine relative to the index. Average Venezuela positions were slightly below the benchmark weight while fund managers were also far underweight on Argentina.
That is unusual for credits with such high yields but clearly, default fears are on the rise as evidenced by the credit default swaps market.
Normally, it is costlier to buy longer-term debt insurance and yields on longer-dated debt are higher than on bonds maturing in the near future. But in the Toxic Trio, the CDS curves are inverted or almost so, a classic sign of credit stress that signals fear of a near-term default.
"The situation in all these three places is so fluid that we are keeping excess risk around the benchmark as low as possible," said Steve Ellis, a fund manager at Fidelity Worldwide Investments.
"I can't recall being underweight (these credits) for any protracted period of time, the carry is too punitive," he said, referring to the yield loss investors incur by not including these credits or just by holding less of them.
At this point, though, it may make sense, says Jeremy Brewin, head of emerging debt at ING Investment Management, who is neutral on high-yield emerging bonds, especially Ukraine.
"The moment to be underweight a high-yield credit is not when it's falling apart but when the price collapse is happening to such an extent that it's a prelude to debt restructuring," Brewin said.
"You have to look not only at the mirror but also at the shadows behind it."
Behind the double-digit yields lie some dismal stories.
The toppling of Ukraine's pro-Russian President Viktor Yanukovich on Saturday probably spells the end of a $15 billion bailout from Moscow, leaving its financial future likely in the hands of the International Monetary Fund.
Ukraine has over $6.5 billion in debt payments this year, empty coffers, an economy in recession and uncertainty about the timing of external financial aid. Repayments rise in 2015 and analysts reckon some debt maturities may have to be extended to give the country some breathing space.
Argentina must repay $6.9 billion this year but is locked in litigation with hedge fund creditors, a process that could push it into technical default if U.S. courts rule against it.
Venezuela, an OPEC member and the world's 11th biggest oil producer, seems an unlikely default candidate but a crippled economy and widespread anti-government unrest is making it likely that urgently needed reforms will not be implemented.
Venezuela and its state oil firm PDVSA must repay $5.5 billion in debt this year, and up to $17.5 billion falls due by end-2017, brokerage Exotix calculates. But by some measures, usable hard currency reserves stand at just $2 billion or so.
That may explain why Venezuela's 9.25 percent 2027 bond is yielding over 14 percent - and finding few takers.
"Our (investment) model suggests we should be overweight Venezuela but from a fundamental point of view we are concerned and that's why we are somewhat dampening down what the model suggests," Fidelity's Ellis said.
As fund managers have fled, year-to-date returns on the bonds of the three countries are around 6-7 percent in the red, pulling down the broader EMBIG index. Other index members, such as Brazil, India, Turkey and South Africa, have returned between 1 and 3 percent so far this year.
So where is a fund manager to go for yield?
A possible refuge is dollar debt from African and other frontier economies which also carry high yields, says Fidelity's Ellis. Belize, Honduras and Armenian bonds for instance have performed strongly this year.
Investors are also positioning in short-dated Venezuelan paper, reckoning oil revenues will allow the country to honour debt in the coming year, while longer bonds look more at risk.
On Argentina, Patrick Esteruelas, head of sovereign research at hedge fund Emso Partners, sees dollar debt issued under local, rather than U.S., law as a safer bet. Even if Buenos Aires is forced into default by the court case, it will honour other bonds to prove its willingness to pay, he argues.
"As much as these high-yield credits present a number of challenges and political risks that are difficult to price, getting them right can essentially make or break your ability to outperform the index," he added.
(Reporting by Sujata Rao; Editing by Peter Graff)