* Fear of sanctions is as bad as sanctions themselves
* Foreign holdings of rouble government debt down sharply
* Russia is worst performer this year in emerging bond index
* South Africa, Hungary and Turkey returning to favour
By Sujata Rao
LONDON, May 8 (Reuters) - Emerging market investors are dumping once-hot rouble bonds due to the threat of tougher sanctions hanging over Russia, shifting funds to the likes of South Africa, Hungary and Turkey which only recently had been unpopular.
Seemingly conciliatory comments from President Vladimir Putin on the Ukraine crisis have soothed markets this week. But fears remain that the West - which has so far targeted only a small number of Russian individuals and firms - will impose harsher sanctions, including on the financial sector.
"The fear of sanctions is as bad as sanctions themselves. The fear is: what could you do with Russian assets if sanctions get ratcheted up?" said Kieran Curtis, a portfolio manager at Standard Life Investments, who has gone overweight Turkish local bonds at the expense of Russia.
Russian government bonds, one of the top emerging market trades of 2012 and 2013, are feeling the heat far more than equities, which have been out of favour for a long time.
Foreign funds held 22 percent of the locally-issued debt at the beginning of March, sharply down from a peak of over 28 percent hit in mid-2013 after Moscow eased investors' access to domestic bond markets.
This share almost certainly fell further in April due to the hardening East-West standoff, with the United States and European Union imposing sanctions after Russia annexed Crimea from Ukraine in March.
Curtis has cut his rouble government bond holdings to below their 10 percent weight in the most widely-used domestic debt index, JPMorgan's GBI-EM, while the reverse is true for Turkey.
He is not alone. Quarterly data from Boston-based EPFR Global shows that debt funds it tracks had an average 9 percent allocation to Russia by the end of March, down from 10 percent three months earlier and 11 percent last October.
That indicates funds have taken an underweight position relative to Russia's share in the GBI-EM.
Overall Russian exposures fell to a new record underweight in April, according to JPMorgan's monthly client survey which also showed rouble exposure in April at the lowest since 2009.
Sanctions or not, Russia is the GBI-EM's worst performer this year, having lost 11 percent in dollar terms while the index gained 3.5 percent. Much of that is down to the rouble which has fallen 6 percent this year against the dollar.
All this has spurred a hunt for alternatives, not all of which have been popular with foreign investors of late. "It's a bit of a struggle and you probably have to get comfortable with something you may not have liked before," Curtis said.
He named Hungary, where some government policies have upset foreign investors, and South Africa, which has suffered from political uncertainty and labour unrest, as the other likely destinations for cash coming out of Russia.
Money leaving Russia is also heading to other members of the "Fragile Five", countries which have been out of favour because of their high reliance on foreign capital for economic growth.
Most of the five - Turkey, Brazil, Indonesia, South Africa and India - have taken steps to rein in their balance of payments deficits since last year.
"The lucky thing from an investor perspective is that the Fragile Five have shown big improvements and that's made people feel comfortable opening positions in those countries with the money they may have invested in Russia," Curtis said.
Bond auctions across these countries have attracted robust demand in recent weeks whereas Russia has cancelled 10 of the 16 scheduled debt sales since the start of this year.
Two issues confront investors looking to switch into other markets - size and yield. Russia not only has a big weight in the GBI-EM, it is also among the highest-yielding at over 9 percent, compared with the index average of 6.8 percent.
Domestic debt markets in some countries in eastern Europe and east Asia are simply not large or liquid enough.
"If you need to exit Russia there are very few places to hide, you can't go to Romania or Philippines. So people are having to move into the big markets such as Turkey or South Africa," said UBS strategist Manik Narain.
Brazil, South Africa and Turkey - each of which comprises a tenth of the index - still offer annual yields of 8 percent or more. Hungary yields 4.3 percent, but returns after hedging for currency risk are among the highest in emerging markets.
Other big markets such as Poland, South Korea or Mexico are less popular, because yields here are too low or positioning is too crowded, Narain said, adding that many clients had switched to South Africa after shunning it at the start of 2014.
"Data and the resilient rand show a recovery of foreign inflows into South Africa which has one of the highest nominal yields in emerging markets," he added.
Flows have been robust. Foreigners have bought more than 17 billion rand ($1.62 billion) worth of bonds since early March, according to the Johannesburg stock exchange.
In Hungary, where the JPM survey showed record-high exposure levels last month, almost 250 billion forints ($1.14 billion) flowed into domestic bonds in March and April, according to the state debt agency. Turkish bonds took in $1.5 billion last month after suffering net outflows in March, central bank figures show.
Bond yields in these countries, unlike in Russia, have been falling. Turkey - which suffered major political uncertainty earlier this year - is down 200 basis points since early March as eased, and South Africa has slipped 40 bps.
"We saw very sharp declines in Turkish yields in literally two weeks or so. The anecdotal evidence is money is going there from Russia," said Steve Ellis, a portfolio manager at Fidelity Worldwide Investments.
Ellis is neutral on Russia, however, reckoning high yields will force many investors to "close their eyes and stay in".
But seeking high Russian yields means shouldering the huge risk of being exposed to a falling rouble.
Investors often hedge or protect themselves against currency risk via derivatives but in Russia's case, political risks and a 200 bps rise in interest rates this year mean hedging costs are prohibitive and would at one stroke wipe out the return.
In other countries such as South Africa, Mexico and Hungary hedging is cheaper so it is possible to make a decent return. These countries' steep yield curves - where longer-dated bonds offer a large premium to short-dated ones - mean that net returns can rise as the curve extends.
So a fund holding 10-year South African bonds can get a net return of around 1.6 percent a year, Narain of UBS estimates, while in Hungary and Mexico returns are 3.5 percent or more.
But investors are watching the Ukraine crisis closely. Any easing in Putin's stance and a reduction in sanctions risk could bring cash back into rouble debt.
"We would want to see moderation of geo-political risk," Fidelity's Ellis said. "But everything has a price ... 9.5 percent yield on the 2027 bond is attractive and if we see another big selloff we may look at taking an overweight position." (additional reporting by Sandor Peto in Budapest and Seda Sezer in Istanbul; editing by David Stamp)