Jan. 2 (Bloomberg) -- International investors are buying Brazilian, Indian and Indonesian bonds, driving the biggest monthly gain in emerging-market debt in at least three years, as central banks cut interest rates to support their economies.

Merrill Lynch & Co.’s LDM Plus Index of local-currency sovereign notes in 18 developing nations rallied 8.2 percent in U.S. dollar terms in December, the most since the index started in 2006. Indonesia’s domestic securities gained 29 percent, India’s climbed 12.6 percent and Brazil’s advanced 6.6 percent, according to Merrill.

Investec Asset Management Ltd., Aberdeen Asset Management Plc and Erste Sparinvest KAG, which together manage more than $6 billion in emerging-market debt, are turning bullish as inflation cools and currencies rally. The index had dropped 6.5 percent in the first 11 months as the worst global financial crisis since the Great Depression caused Pakistan, Ukraine and Hungary to seek loans from the International Monetary Fund.

“Investors expect rate cuts across many countries with no inflation problems going forward over the next couple of years,” said Anton Hauser, who manages $1.2 billion in emerging-market debt in Vienna at Sparinvest, part of Austria’s biggest bank by market value. “This means quite good returns on local-currency bonds in general.”

Policy makers are shifting focus from fighting inflation as recessions in the U.S., Europe and Japan erode export demand, shrinking wages and reducing raw material costs. The World Bank predicted on Dec. 9 growth in developing economies will slow to 4.5 percent in 2009, from 6.3 percent last year, as global expansion cools to 0.9 percent.

Rate Cuts

The Reserve Bank of India today slashed its repurchase rate for a fourth time in less than three months to 5.5 percent as wholesale price increases slowed to 6.4 percent last month, from a 16-year high of 12.9 percent in August. India’s growth may slow to 7 percent in the year ending March 31, from 9 percent or more the previous three years, the government said Dec. 23.

Bank Indonesia lowered its benchmark for the first time in a year on Dec. 4 to 9.25 percent. Brazil, Thailand and Mexico will cut borrowing costs this month, according to Bloomberg surveys of economists.

Developing-nation debt plunged for much of 2008 as credit losses mounted, prompting investors to hoard cash and pare investments in everything but the safest government securities. Outflows from emerging-market bond funds averaged $800 million in the 19 weeks ended Dec. 17, according to EPFR Global, a Cambridge, Massachusetts-based research company.

Currency Swings

The LDM Plus Index rose 1.1 percent in dollar terms in 2008, compared with a 12.9 percent gain before adjusting for foreign-exchange swings. Returns for U.S. currency investors were 13.9 percent in 2007 and 12.7 percent in 2006. U.S. Treasuries returned 14 percent in 2008, a separate Merrill index shows.

“I would basically avoid all emerging markets for the first six months of 2009 with the possible exception of China and India,” said Arjuna Mahendran, Asia chief investment strategist in Singapore for HSBC Private Bank, which manages $494 billion in assets. “In a recession, it’s very difficult to raise taxes.”

Pakistan is an “extreme case” of the risk as raising tax income is a condition of its $7.6 billion IMF loan, he said.

The Korean won weakened 26 percent last year, the Brazilian real 23 percent, the Indian rupee 19 percent and the Indonesian rupiah 15 percent on concern governments and companies would struggle to meet overseas obligations. South Korea’s government last month said it is considering providing aid to carmakers and Russia approved a list of 295 companies to receive state support.

Financing Plans

Developing nations may increase sales of dollar-denominated debt 68 percent to $65 billion this year to plug budget deficits, according to ING Groep NV. Reliance on foreign markets led countries across Latin America to default in the 1980s, according to Ricardo Hausmann, director of the Center for International Development at Harvard University in Cambridge, Massachusetts.

The risk of default is easing as access to foreign currency improves. The London interbank offered rate, which banks charge each other for three-month dollar funds, declined to 1.41 percent from as high as 4.82 percent on Oct. 10. Outflows from emerging-market bond funds also slowed to $69 million in the week ended Dec. 17, the least in 18 weeks, EPFR said.

“Investors intensified their search for yield in mid- December,” EPFR said.

‘Very Bullish’

The yield on the 9 percent Indonesian government note due September 2018 fell 3.69 percentage points last month to 11.86 percent. Sparinvest will “most likely” buy Indonesian bonds, Hauser said. A Bloomberg survey shows the yield may drop to 10.8 percent this year, providing investors with local-currency returns of 18 percent.

The yield on the benchmark Brazilian five-year bond slid 3.82 percentage points last month to 13 percent. Economists lowered their forecast for the Central Bank of Brazil’s 13.75 percent benchmark overnight rate to 12.25 percent by the end of the year, from 13 percent the previous week, according to the median forecast in a central bank survey of about 100 institutions published on Dec. 22.

The Brazilian real will gain 2.4 percent against the dollar in the next 12 months, enhancing returns for investors, according to the median estimate of 19 analysts in a Bloomberg News survey. The Indian rupee will advance 1.6 percent to 48, while the Indonesian rupiah will rise 1.2 percent to 11,000, separate surveys showed.

High Yielders

“The higher yielders, such as Brazil, Turkey, Hungary, Colombia, Indonesia are our picks,” said Peter Eerdmans, head of emerging-market bonds at Investec Asset Management in London, which manages a total of $700 million in global emerging-market debt. “We are still very bullish.”

Brazil’s inflation rate may end 2008 at 6.2 percent before falling to 4.7 percent this year, the central bank said last month. Indonesia’s price increases may slow to 7.5 percent this year, from 10.5 percent last year, according to a Bloomberg survey of economists.

“Central banks are going to have to turn their policies to be much more accommodative,” said Kenneth Akintewe, portfolio manager in Singapore with Aberdeen. Scotland’s largest independent fund manager, which manages $160 billion in assets, is bullish on Indian, Thai and South Korean debt.

Thailand, which reduced its benchmark rate by the most ever to 2.75 percent on Dec. 3, may reduce it to 1.5 percent this year, Akintewe said.

“Rate cuts are happening at a much faster pace,” said Rachana Mehta, head of fixed-income in Singapore at KE Capital, a venture between Kim Eng Holdings Ltd. and Mitsubishi UFJ Securities Co. set up in June 2008. “I haven’t seen opportunities like these since the Asian crisis a decade ago.”

She favors bonds in India, South Korea and the Philippines.

To contact the reporters on this story: David Yong in Singapore at dyong@bloomberg.net; Lilian Karunungan in Singapore at lkarunungan@bloomberg.net

Last Updated: January 2, 2009 07:55 EST