Feb. 18 (Bloomberg) -- Hungarian, Polish and Czech government debt, among the highest rated in emerging markets, has already been downgraded by bondholders.

Investors are demanding 20 basis points more yield to own Hungary’s bonds than similar-maturity Brazilian debt, which is rated four levels lower by Moody’s Investors Service, JPMorgan Chase & Co. indexes show. The risk of Poland defaulting is about the same as Serbia, ranked six levels lower by Standard & Poor’s, based on credit-default swap prices. Czech 10-year bonds yield the most compared with German bunds since 2001.

“Everybody is running for the door,” said Lars Christensen, head of emerging-market strategy at Danske Bank A/S in Copenhagen. “The markets have decided the central and eastern European region is the subprime area of Europe.”

Investors who lost more than 18 percent on emerging-market sovereign and corporate bonds last year based on Merrill Lynch & Co. indexes now face steeper declines in Eastern Europe, said Christensen. While the region’s integration with the European Union spurred foreign investment earlier this decade, Poland’s currency weakened 35 percent against the euro since August, the Czech economy cooled to the slowest pace in almost 10 years in the fourth quarter and Hungary required a bailout from the International Monetary Fund.

Monitoring ‘Very Closely’

“Hungary is the one that we are monitoring very closely,” Dietmar Hornung, senior analyst in Frankfurt, said in a phone interview today. “The ratings as they are reflect to a certain degree the assumption that it is rating positive to be a European Union country.”

Hungary’s bonds lost nearly 12 percent last year after returning 9.4 percent in 2007 and returns on Poland’s bonds shrank to 1.3 percent from 9.1 percent in the same period, Merrill indexes show. Investors in Romania’s bonds, which are yielding nearly double those of Egyptian debt rated one level lower in non-investment grade, lost more than 12 percent last year, the indexes show.

Emerging Europe will post an average current account deficit of 4.1 percent of gross domestic product this year, more than double the 1.7 percent deficit in Latin America and trailing surpluses in Asia, Africa and the Middle East, according to Citigroup Inc. data on Czech, Poland, Hungary and five other economies the region.

Weaker Currencies

The region’s economies are set to shrink 0.4 percent this year as demand for their exports and commodities falters, from an average 3.2 percent growth in 2008, according to the International Monetary Fund. The IMF granted more than $35 billion in aid to Hungary, Ukraine, Latvia, Serbia and Belarus to avert defaults.

“There is no doubt the countries are struggling with large imbalances and significant currency mismatches,” Christensen said. “The only way for this to go is weaker currencies and a significant slowdown in domestic demand, leading to more balanced economies.”

East European stocks slumped to the lowest level in more than five years after Moody’s said yesterday that banks with subsidiaries in the region face rating cuts. The MSCI EM Eastern Europe Index was 6 percent lower at 10:30 a.m. in London. Poland’s WIG20 index declined 3 percent to the lowest in more than five years, after dropping 7.5 percent yesterday.

The Hungarian forint, which weakened to the lowest ever against the euro yesterday, climbed 0.6 percent today. The Polish zloty held near a five-year low and the Czech koruna strengthened 0.7 percent after touching the lowest since 2005 yesterday. The currencies are among the world’s 10 worst- performers this year against the euro.

As recently as June 2007, Czech 10-year bonds yielded less than German bunds of similar maturity. The securities now yield 1.63 percentage points more, the highest since 2001, according to data compiled by Bloomberg.

Rising Protection Costs

The cost of protecting payment on Poland’s debt has risen more than six times in the past six months to 405 basis points, credit-default swaps show. The cost is about the same as on contracts linked to Serbia, which is rated three levels below investment grade at BB- by S&P, Bloomberg data show.

Prices for the contracts rise as perceptions of credit quality deteriorate. A basis point is equivalent to $1,000 on a contract protecting $10 million of debt.

The extra yield investors demand to own Hungarian sovereign or quasi-sovereign bonds instead of U.S. Treasuries has risen almost three-fold in the past six months to 4.71 percentage points, more than the 4.51 percentage point spread for Brazilian debt, JPMorgan data show.

‘Fear of Crisis’

“Hungary is the most vulnerable.” Frankfurt-based Standard & Poor’s analyst Kai Stukenbrock said in a phone interview. “External leveraging is not as high in Poland. The Czech Republic is the least exposed.”

S&P and Moody’s cut Hungary’s credit ratings in November, after the country struggled to service its short-term debt amid the global financial crisis. Hungary’s rating was downgraded to A3 from A2 by Moody’s and to BBB from BBB+ by S&P. Both ratings companies have “negative” outlooks on Hungary, meaning the country’s grade is more likely to be cut again than raised or left unchanged.

Poland has an A2 rating from Moody’s and an A- rating from S&P. The Czech Republic has an A1 rating from Moody’s and an A rating from S&P. Both ratings have “stable” outlooks.

“The fear of crisis is increasing,” said Ralph Sueppel, chief economist and strategist at London hedge fund BlueCrest Capital Management Ltd., which manages about $2 billion in emerging-market assets.

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

Last Updated: February 18, 2009 06:38 EST