(Bloomberg News) Bond yields in emerging markets are falling to record lows as inflation tumbles compared with benchmark interest rates, providing policy makers with more opportunities to lower borrowing costs.

The GBI-EM Global Diversified Index on emerging-market bond yields declined 79 basis points, or 0.79 percentage point, this year to 5.79 percent, the lowest since JPMorgan Chase & Co. started to compile the data in 2003. Consumer price increases in 15 developing nations from Brazil to China slowed to an average 4 percent last month, even as central banks cut the mean policy rate to 5.5 percent. The 1.5 percentage-point gap was the widest since December 2009, according to data compiled by Bloomberg.

Slower inflation and weaker economic growth will prompt policy makers to reduce interest rates further, spurring gains in developing-nation bonds, according to GAM Investment and JPMorgan Chase & Co. That's a turnaround from four years ago, when inflation exceeded benchmark borrowing costs and investors fled emerging markets as the global economy sank into a recession.

"Rates are coming down and there are no signs of inflation, which is the classic bond bull market type of territory," Paul McNamara, who oversees $6.5 billion in emerging-market debt as a money manager at GAM Investment, said in a telephone interview from London. "Emerging-market bonds still offer pretty good value."

Record Low

South Africa's central bank unexpectedly cut its benchmark interest rate by half a percentage point today to 5 percent. Yields on rand-denominated bonds due in 2021 fell 21 basis points to a record low of 6.58 percent, extending their drop this year to 137 basis points.

The JPMorgan GBI-EM Global Diversified Index returned 8.2 percent in local-currency terms this year. U.S. government debt has gained 3.4 percent, with yields falling 20 basis points to 0.85 percent, according to Bank of America Corp.'s U.S. Treasury Master Index.

Central banks in the U.S., the U.K. and the euro area have reduced benchmark borrowing costs to levels at least 1.7 percentage points below inflation. In Brazil, Russia and China, borrowing costs are more than 3 percentage points above inflation, the highest real rates among the Group of 20 nations, data compiled by Bloomberg show.

With global growth slowing, emerging-market bonds have tracked developed nations' debt, a change from the past when investors abandoned all but the safest assets during economic disruptions. Investors are more confident that the countries can repay debt and cut interest rates without igniting inflation, according to Pioneer Investments.

Risk Perception

"In the past when there's negative news, you want to sell everything, the bonds, currencies and stocks" in developing nations, Hakan Aksoy, who helps oversees 2.8 billion euros ($3.4 billion) in emerging-market debt at Pioneer, said in a telephone interview from London. "Now, you don't have the same feeling. The perception of risk has changed."

Average yields on Brazilian bonds dropped 198 basis points this year to 8.61 percent and reached a record low of 8.56 percent on July 16. China's slid 30 basis points, or 0.30 percentage point, to 3.1 percent and hit a three-year low of 3 percent this month.

Brazil Rates

When global economic growth collapsed in 2001, yields on two-year Brazilian notes jumped 425 basis points to 21.4 percent as the central bank raised its benchmark Selic rate five times to slow capital outflows, support the currency and combat inflation. Argentina defaulted on $95 billion in bonds that year. In 2008, the JPMorgan index's yield surged to a record 9.7 percent after Lehman Brothers Holdings Inc.'s bankruptcy prompted investors to pull money out of emerging markets.

The JPMorgan index's yield fell a record 61 basis points in 2010 as inflation allowed central banks to keep benchmark interest rates close to record lows through the first half. The gauge returned 11 percent that year, the most since 2004.

Depreciating emerging-market currencies have eroded returns for foreign investors. The JPMorgan index advanced 1 percent during the past year when translated into dollars, compared with a gain of 13 percent in local-currency terms. Brazil's real, the South African rand and the Hungarian forint weakened at least 15 percent during the period.

Commodities Prices

Further currency declines and rising food prices may limit bond gains, according to UBS AG, which advised its clients this month against adding emerging-market securities. A food price "shock" has the potential to "very quickly alter the trajectory" of inflation, Bhanu Baweja, a London-based strategist, wrote in a report yesterday.

Corn futures rose to a four-year high this week, while soybean contracts became the most expensive on record and wheat was the costliest since 2008 as a U.S. drought damaged crops. Food and energy costs account for an average 36 percent of the consumer price indexes in emerging markets, Bank of America said in a December report.

The drop in yields is "stretched" as a second-half rebound in economic growth may limit the scope for further interest-rate cuts, said Peter Eerdmans, who oversees about $11 billion as head of emerging-market debt at Investec Asset Management Ltd. The London-based money manager has been reducing holdings of bonds in Mexico and South Africa as yields fall.

Weak Growth

"If we do see a pickup in growth in the second half of the year, there's no reason for central banks to cut rates," said Eerdmans.

Jan Loeys, the chief market strategist at JPMorgan in New York, says policy makers will keep reducing borrowing costs. He sees "greater opportunities" for investors in emerging-market bonds than in the developed world.

"Continued weak global growth and easier monetary policy are ideal for fixed income," Loeys wrote in a July 13 report. He recommended holding more local emerging-market bonds than are represented in benchmark indexes while hedging currency movements.

The European debt crisis is eroding exports from developing nations, curbing growth and keeping inflation in check. China's expansion has slowed for six straight quarters, dragging the consumer price index to a 29-month low. Brazil's retail sales fell 0.8 percent in May, the biggest drop since November 2008, while inflation declined to a two-year low of 4.92 percent last month.

Brazil Outlook

Brazil cut its benchmark interest rate to a record 8 percent on July 11 and China reduced its one-year lending rate for the second time in a month to 6 percent on July 6. Eighteen developing nations have cut borrowing costs so far this year, data compiled by Bloomberg show.

Brazil's central bank signaled it will cut interest rates at least once more even as it predicts that economic activity accelerating during the remainder of the year, according to the minutes of its July 10-11 meeting released today.

The Turkish central bank held its benchmark one-week repo rate at 5.75 percent today, in line with the forecasts of all eight economists surveyed by Bloomberg.

Countries including China, India, South Korea, Hungary, Israel, Russia, Brazil and Chile will lower interest rates further in 2012, according to Bank of America.

IMF Forecasts

Emerging markets should "stand ready to adjust policies" as growth slows, the International Monetary Fund said in a July 16 report. The Washington-based lender cut its 2012 growth forecast for developing economies to 5.6 percent from the previous estimate of 5.7 percent in April.

"The slowing is at its initial stage yet and inflation is not really a theme," said Phillip Blackwood, who oversees $2.9 billion in emerging-market debt as a managing partner at EM Quest Capital LLP in London. "We see the slowdown has further way to go across the emerging markets, but we are not too scared. That will at least give some further drops in bond yields."

Blackwood said South Africa's local bonds are among his favorites as they haven't fully reflected "benign" growth. Yields on JPMorgan's Index of South African securities dropped 94 basis points this year and reached an all-time low of 7.02 percent on July 17. Citigroup Inc. said last month it would include the debt in its World Government Bond Index, fueling demand from money managers who track the gauge.

Boosting Returns

With 10-year U.S. Treasury and German bund yields falling below 1.5 percent, investors are seeking alternatives to boost returns. After accounting for inflation, U.S. benchmark debt has a yield of negative 21 basis points. The average yields of developing-nation bonds are 429 basis points higher than those of 10-year U.S. Treasuries, compared with the average spread of 397 during the past five years.

Government debt in developing nations amounts to 36 percent of this year's gross domestic product, compared with 107 percent for advanced economies, according to IMF estimates.

Bill Gross, who runs the world's largest mutual fund at Pacific Investment Management Co., said he favors Mexico's bonds over German bunds as the Latin American country has lower debt levels and higher yields. Mexico's BBB rating from Standard & Poor's is eight levels below that of Germany, the largest economy in Europe.

"Let's see: would I rather own German or Mexican 10-yr bonds? 1.5% or 5.7%? Huge potential debt/GDP or half that of U.S.?" Gross said in a posting on the Twitter website on June 18. "Duh."