Sept. 4 (Bloomberg) -- Iceland's krona, the world's worst performing currency in the first half of 2006, is back on top as hedge funds find the country's bonds irresistible.

The krona has soared more than 10 percent against the dollar this quarter, erasing almost half the loss, and beating gains of 8 percent in the Turkish lira and New Zealand's dollar. The advance is being spurred by investors borrowing in countries such as Japan, where interest rates are 0.25 percent, and buying Icelandic treasury bills, which yield 13.90 percent.

``They pay you a lot of money,'' said John Taylor, chairman of FX Concepts Inc., a New York-based investment firm with $12 billion in assets and clients including hedge funds and pension funds. ``We've owned it, we've been short, it's been a nice ride.'' Investors who short the krona bet on a decline by selling currency they have borrowed, aiming to purchase it later at a lower price.

Iceland's currency is rebounding as global investors resume the so-called carry trade, a strategy of borrowing cheaply and investing in countries with higher returns. The difference in yields helped Iceland's krona surge more than 60 percent in the previous four years only to plunge 17 percent during the first half as concerns grew about the country's burgeoning debt.

The krona may gain another 6 percent before year-end as slower growth in the U.S. and Japan convinces investors the Federal Reserve and Bank of Japan are unlikely to raise rates again this year, said Momtchil Pojarliev, a currency manager in Geneva at Pictet & Cie, which oversees about $168 billion.

Iceland's treasury bills due in November yield 8.98 percentage points above similar-maturity U.S. Treasury bills, 13.54 percentage points above Japan's bills and 10.86 percentage points more than German debt.

`Biggest Hedge Fund'

``This could be the time to buy the krona,'' said Pojarliev. ``The current level of rates is quite high. I'm bullish.''

Iceland's currency climbed to 68.97 krona to the dollar at the end of last week, from 76.03 on June 30. Pojarliev forecasts it will appreciate to 65 per dollar by year-end.

Iceland ran into trouble as banks and manufacturers borrowed overseas to fund growth, a similar strategy pursued by Thai companies prior to the Asian financial crisis in 1997. Iceland's foreign borrowing jumped to 3.7 trillion kronur ($53.6 billion) in March, from less than 1 trillion in 2002, according to central bank data published in June.

New York-based Fitch Ratings on Feb. 21 lowered its outlook on Iceland's AAA rated debt to ``negative,'' citing its rising debt load. ``People have described Iceland as the biggest hedge fund of all,'' Richard Fox, a senior director at Fitch in London, said in an interview at the time.

Riskier Than Poland

Fitch's announcement sparked the biggest one-day decline in the krona since 2001, a 4.4 percent drop against the dollar. Iceland's imbalances haven't ``turned around yet,'' said Paul Rawkins, a senior director at Fitch in London. ``Our negative outlook on the debt rating is still appropriate.''

Investors demanded yields to compensate for the risk that were so high that Iceland's finance agency abandoned sales of benchmark bonds at monthly auctions in February and March. Yields on the 7 percent notes due in 2010 increased half a percentage point in three weeks.

By late March, investors perceived Iceland as more risky than Poland, which has a credit rating six steps lower, according to traders in the credit-default swap market. Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on an increase or decrease in indebtedness.

``You have a tendency for high-yielding currencies to appreciate, but they can also have big corrections,'' said David Karsboel, a Copenhagen-based market strategist at Saxo Bank A/S, which runs two hedge funds with $125 million. ``We stayed out of the krona altogether'' because ``there's massive risk.''

Recession Risk

The krona slid further as economists at Danske Bank A/S, the second-largest Nordic bank by market value, said on March 21 the economy would fall into recession and the currency would fall 25 percent in 12 months. The report sent the krona down 2.6 percent that day. The benchmark stock index, the ICEX 15 index, fell 10.6 percent in March, the most since October 2004.

Icelandic policy makers blamed foreigners for the meltdown. ``Without naming anyone in particular, quite a lot of what we read is exaggerated and doesn't necessarily reflect careful analysis of the situation,'' Ingimundur Fridriksson, the assistant governor of the nation's central bank, said in a March 28 interview in Reykjavik.

Borrowing in Japan

Investors are stepping up borrowing in Japan as evidence mounts that the Bank of Japan will keep borrowing costs low. BOJ Governor Toshihiko Fukui said Aug. 4 he will keep increases in rates ``gradual.'' Government reports this month showed Japan's gross domestic product and consumer prices are rising less than economists forecast, reducing the need for higher rates.

The Icelandic krona, New Zealand dollar and Turkish lira were the biggest beneficiaries last month. New Zealand's benchmark interest rate is 7 percentage points above the BOJ's and Turkey's is 17.25 percentage points higher.

The krona posted its biggest two-month advance against the dollar since 2004 in August after the Icelandic central bank lifted its benchmark rate to a record 13.5 percent. The bank has raised rates by 7.7 percentage points since May 2004 as a booming economy doubled the inflation rate to 8.6 percent.

Thorsteinn Thorgeirsson, the chief economist in Iceland's Ministry of Finance, said the rise in the country's currency isn't a surprise. ``We had assumed a strengthening in the second half,'' he said. ``The average value of the krona is broadly in line with our forecast.''

`Get Back In'

The $14 billion economy will expand 5.5 percent this year, the same pace as last year, following an 8.2 percent gain in 2004, the strongest period of growth according to International Monetary Fund figures dating from 1980.

``With yields over 13 percent, funds are going to be looking at Iceland again,'' said Peregrine Hood, a trader in Geneva at broker Bridport & Cie, who advised some of his hedge-fund clients to buy the krona this month after telling them to exit the currency in November. Clients ``have started to get back into Iceland.''

To contact the reporter on this story: Kabir Chibber in London at kchibber@bloomberg.net.

Last Updated: September 3, 2006 11:02 EDT