The longest emerging-market currency rally in five years is faltering on speculation rising foreign ownership of local debt will leave nations from Indonesia to Brazil vulnerable to capital flight.

Overseas holdings of domestic bonds in 12 countries have risen to about 26 percent of outstanding debt from 25 percent in February and close to the record 27 percent in May 2013 that preceded a foreign-exchange selloff, according to Goldman Sachs Group Inc. All except four of 23 developing-nation currencies will weaken by year-end, led by Argentina’s peso and the Brazilian real, analysts surveyed by Bloomberg predict.

Money managers are anticipating the end of the record-low borrowing costs and unprecedented amounts of cheap central bank cash that have driven this year’s advance in higher-yielding assets. They’re also concerned that a slump in growth across the developing world will weigh on currencies. Citigroup Inc.’s Economic Surprise Index for emerging markets has been below zero since March, indicating that data trailed forecasts.

“When valuation is stretched and positions are crowded, anything could be a catalyst for a selloff,” Guillermo Osses, the head of emerging-market debt at HSBC Global Asset Management in New York, said in a June 27 phone interview. “We’ve not seen economic fundamentals improve as much as we’d like, which tends to suggest we’re likely to see some weakness in coming months.”

‘Underweight’ Positions

Osses, whose firm oversees $430 billion, said he’s the most pessimistic about developing-nation assets in a “couple of years,” with “very large underweight” positions in eastern European currencies and Mexico’s peso.

A Bloomberg index of the 20 most-traded emerging-market currencies was unchanged in June, ending four straight months of gains that marked the longest winning streak since July 2009. The gauge, which tracks currencies from the real to Russia’s ruble and South Africa’s rand, had surged 4.7 percent from a five-year low on Feb. 3 to its 2014 high in May.

By the end of 2014, the Argentine peso, which the central bank devalued 19 percent in January, is forecast by analysts surveyed by Bloomberg to tumble 13 percent versus the dollar amid concern the nation is on the brink of a debt default.

Mexican Peso

The real, this year’s best performer among 31 major currencies tracked by Bloomberg, will drop about 8 percent, with the ruble losing more than 4 percent, according to the forecasts. Mexico’s peso will lead emerging-market increases with a 1 percent advance, while three other expected gainers, including China’s yuan, are in Asia.

“The risk-return profile is becoming less compelling,” Michael Ganske, who oversees $8 billion in currencies and bonds as the head of emerging markets at Rogge Global Partners Plc in London, said by phone on June 27. “We’re more cautious than a couple of months ago.”

Foreign investment in local-currency bond markets has surged from just 10 percent at the start of 2010, according to Goldman Sachs. International holdings of Indonesian debt rose to 39 percent of outstanding securities in May, the highest in about four years, while ownership of Brazilian debt climbed to about 19 percent in April, from 14 percent in May 2013. More than a third of Mexican, Hungarian and South African local debt is in the hands of foreigners, Goldman Sachs data show.

Value Remains

Some traders expect the rally in local-currency debt has further to run. The bonds are still more attractive than equivalent dollar securities, with a yield premium of about 1.3 percentage points, the most since 2008 and up from 0.7 percentage point at the end of last year, according to JPMorgan Chase & Co.

“Foreigners are holding local bonds in emerging markets to diversify their bond portfolio,” Peter Marber, the head of developing-nation investments at Loomis, Sayles & Co. LP, said by phone from Boston on June 27. Those who don’t buy them are “missing out,” he said.

The pullback in monetary easing that some investors say will spark a currency rout has already started. The Federal Reserve is on track to end its bond-purchase program this year, while the Reserve Bank of New Zealand in March became the first central bank among developed nations to lift interest rates since 2011. The Bank of England signaled the start of a normalization in borrowing costs last month.

Volatility Risk

Investors are concerned that the decline in stimulus will trigger an increase in currency price swings. JPMorgan’s Global FX Volatility Index fell yesterday to an all-time low, making it more profitable to buy emerging-market currencies.

A slowdown in developing economies is another risk. Bank of America Corp. kept its 2014 growth forecast at 4.5 percent this week, compared with 4.7 percent for both 2012 and 2013 and 6.2 percent in 2011.

The World Bank warned June 26 that investors in emerging markets might “under-price risk,” paving the way for a “sudden spike in volatility and sharp adjustment” when the U.S. target lending rises from a record low range of zero to 0.25 percent.

With higher borrowing costs, “local-currency bonds and exchange rates are more vulnerable,” Simon Quijano-Evans, the head of emerging-market research at Commerzbank AG in London, said in a June 30 phone interview. “We’re going to see more risk.”

Bloomberg