LONDON, Sept 6 (Reuters) - Nerves over North Korea knocked emerging market stocks and pushed the cost of insuring Seoul's debt to the highest this year on Wednesday, but a rally in bonds drove average local debt yields below 6 percent for the first time since early 2015.
Appetite for EM equities waned again as South Korean President Moon Jae-in told Russia's Vladimir Putin the situation on the Korean peninsula could become unpredictable, after a top North Korea diplomat had promised more "gift packages" for the United States.
MSCI's emerging stock index dropped 0.4 percent, with a fifth straight day of losses in South Korea compounded by falls across EM markets from Russia to South Africa.
The cost of South Korean credit default swaps, a derivative investors use to protect them against rising risk aversion, was also at its highest of the year, as the contract rose by 5 basis points to 72 bps, according to data provider Markit.
But the moves have not been enough to derail the year's blistering rally in emerging markets. The benchmark MSCI stock index is up over 25 percent this year, following an eight-month long rally that saw it hit a three-year high last week.
The average yield on emerging market local-currency debt, as tracked by JP Morgan, fell below 6 percent on Wednesday too for the first time since February 2015, reflecting strong appetite for bonds.
Underscoring that demand further, $7 billion economy Tajikistan is readying a $1 billion bond. It will be the second poorest country after Ethiopia to tap global borrowing markets.
"EMs have really been supported by lower U.S. rates and the rally seems really powerful because despite this rebound of risk aversion nothing really happens," said Credit Agricole senior emerging market strategist Guillaume Tresca.
"That being said the room for further EM performance is really shrinking. Valuations are quite high so we are turning a little bit more cautious than before."
The simmering North Korea tensions and global risk-off mood meant most emerging market currencies were slightly weaker on Wednesday, though losses were kept in check by the recent bout of dollar weakness.
The Russian rouble outperformed, rising 0.4 percent and adding to gains from Tuesday, when a sharper-than-expected fall in inflation and jump in oil prices encouraged investors to pile into Russian bonds.
Commerzbank analysts said in a note that they saw further upside for the rouble in the short term, predicting only cautious rate cuts by the Russian central bank.
Among other risers, the Chinese yuan gained 0.2 percent against the dollar and the Malaysian ringitt strengthened to a near 10-month high after data showed exports surged more than expected in July.
In a sign that investor appetite for emerging markets could be starting to ease, however, a survey from the Institute of International Finance showed on Tuesday that investors cut capital flows to EM debt and equities in August.
Inflows fell to $15.8 billion, the lowest level since January's $13.2 billion reading.
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Reporting by Alexander Winning and Marc Jones; Graphic by Marc Jones; Editing by Catherine Evans