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Shrugging off tapering, falling emerging debt yields breach key level

* Narrowing trend may soon run out of steam - analysts

View related to emerging market growth expectations

By Carolyn Cohn

LONDON, May 9 (Reuters) - The premium which emerging dollar bonds hold over U.S. yields has shrunk to a level not seen since May 2013 when the Federal Reserve flagged plans to taper its stimulus programme and triggered a sell-off in the risky asset class.

Now analysts and investors are wondering how far the tightening in the premium can go. Their views are largely related to expectations for emerging market growth - and suggest the narrowing trend may soon run out of steam.

Emerging sovereign - or government - dollar bond yield spreads relative to U.S. Treasury yields, as measured on the benchmark JPMorgan emerging market global bond index , squeezed in this week below the key 300 basis point level, indicating buoyant demand for the asset class.

Investors have become accustomed to the U.S. Federal Reserve scaling back, or tapering, its stimulus programme which had boosted demand for high-yielding emerging market assets.

Emerging bond funds have taken in new money for several weeks in a row after months of outflows, data from fund tracker EPFR Global shows. And investors have been switching from high-yield corporate debt from the developed world to emerging markets with an eye on the yield pick-up that trade offers.

"There is still some value there and tapering is largely priced in," said Marc Balston, emerging debt strategist at Deutsche Bank. "We can go below last year's levels, given where credit elsewhere is trading, but I would caution how much further we can go."

The spread level has frequently fallen below the 300 bps level, most notably in 2007 - before the 2008-09 global financial crisis - when it hit a record low close to 150 bps, though higher U.S. yields at that time meant overall emerging debt yields were not at record low levels.

But spreads ballooned during the crisis, at 750 bps at their height, never to return to anywhere near those pre-crisis levels.

A break through the 300 bps level has in the more recent past started investors talking about emerging market bubbles of the kind seen in late 2012, when spreads tightened below 270 bps.

The sell-off after then-U.S. Federal Reserve chairman Ben Bernanke's May 2013 speech took spreads to a high of nearly 400 bps and a rise in U.S. Treasury yields from super-low levels also pushed up the overall average yield of emerging debt.

FALLING GROWTH

While investors have focused on the Fed, market specialists said falling growth expectations in emerging markets, often linked to lower growth expectations for China, also contributed to the sell-off.

Balston looks at the link between consensus forecasts for growth in emerging markets and the debt spreads, which he said have supported the recent narrowing in spreads.

Growth expectations narrowed last year to 1.4 percentage points above developed markets, from 2.3 points.

"It now seems to have stabilised at that point and spreads have come in quite a lot," he said.

U.S. yields have also subsided - 10-year Treasury notes are yielding 2.6 percent, where yields above 3 percent were anticipated. That points to overall yields for emerging sovereign debt of 5.6 percent on average, compared with 5.1 percent a year ago, and as much as 6.5 percent at the time of record low spreads in 2007.

Frontier market spreads, a growing higher-yielding asset class, have enjoyed an even quicker tightening process, narrowing 120 bps from the start of the year and retracing 80 percent of their losses, compared to 70 percent for the broader index.

Leaving aside Ukraine, which is suffering due to the conflict with Russia, investors have shown a change of heart towards other high-yielding debt markets, due to waning fear of default or local economic reforms.

"Argentina, Venezuela are performing well," said Stuart Culverhouse, chief economist at frontier markets broker Exotix, adding: "There are arguments that emerging market risks could continue to fall - maybe growth slowdown has reached its maximum and will begin to pick up."

But Steve Ellis, a portfolio manager at Fidelity Worldwide Investments, looks at spreads against emerging market PMI data, and says this correlation is flashing warning signals.

"Those are suggesting the spread is near the bottom end of the range. If growth starts picking up in emerging markets, we will become more bullish," he said.

The HSBC composite emerging markets PMI index picked up slightly in April to 50.4, but is only just above the 50 level which separates growth from contraction.

And Grant Webster, emerging debt fund manager at Investec, was doubtful that spreads could tighten much further after their recent strong run, following outlook and rating downgrades for emerging economies over the past year.

"(Spread tightening) is possible but valuation-wise it doesn't make sense - credit quality is stable to slightly deteriorating."

(Additional reporting by Sujata Rao; Editing by Janet Lawrence)