LONDON, Oct 5 (Reuters) - Yield premiums on dollar bonds from smaller and riskier emerging markets over larger developing markets have shrunk to the tightest levels in a decade, said JPMorgan, which runs the most widely used emerging debt indexes.

Emerging markets are among this year’s best performing assets due to hefty inflows from investors seeking alternatives to rock-bottom yields across developed markets and encouraged by improving economic data from the developing world.

The bank’s NEXGEM index tracks dollar-denominated government bonds issued by so-called frontier markets. It has seen spreads over the wider emerging debt benchmark fall to around 100 basis points - the tightest since 2007.

Foreign investors are expected to plough some $1.1 trillion of capital into emerging markets this year, according to the Institute of International Finance.

In a note received on Thursday, JPMorgan analyst Benjamin Shatil told clients that “much of NEXGEM’s continued outperformance looks to be a reflection of broader EM sentiment amid strong inflows into the asset class, reflecting search for yield, the role of ETF inflows, as well as a relatively accommodative commodity price and broad dollar backdrop.”

The 34-country NEXGEM index, which includes countries such as Sri Lanka and Mongolia, has returned more than 12 percent this year, compared with 9 percent on the EMBIG which contains bigger countries such as Russia and Brazil.

NEXGEM’s average yield spread over Treasuries have contracted 104 basis points this year to 372, while EMBIG spreads have declined by 56 bps, JPM data shows.

But current spread levels may fail to reflect economic fundamentals such as public debt to GDP ratio, which has climbed more than 14 percent since the end of 2008 in frontier markets.

“The rise in public debt has been a consistent trend across the bulk of sovereigns in our sample, with only a handful of notable exceptions,” Shatil wrote.

The International Monetary Fund warned in April of risks to developing economies from a more rapid rise in global interest rates, a large appreciation in the U.S. dollar and lower commodity prices.

INVESTOR ENTHUSIASM

Yet, with several frontier economies signed up to IMF loan programmes, many investors expect more prudent monetary and fiscal policies to dominate, said Kaan Nazli, senior economist for emerging debt at Neuberger Berman.

Despite the contraction, “the NEXGEM spread is still attractive over the EMBIG,” Nazli said.

The IMF approved a programme for Sri Lanka in June 2016, while Mongolia was granted a bailout in May. In August, the fund extended an aid package for Ghana.

But frontier markets - traditionally used to diversify emerging debt portfolios - were increasingly trading in line with broader emerging assets, according to Nazli.

“Traditionally, they had a low correlation with emerging markets, but my sense is that has changed a lot since the start of the year,” he said.

Looking at positioning across frontier debt markets, JPMorgan found investor exposure was at historical highs across all regions. But changes were most dramatic in Latin America, central America and the Caribbean as well as Sub-Saharan Africa.

“These regions may also be most susceptible to a change in positioning, particularly if moves occur on the back of global liquidity conditions or other beta factors rather than idiosyncratic country-level factors,” the bank wrote.

Looking at possible stress scenarios, the bank identified a number of countries that could suffer most.

“The public debt stock in Ghana, Jamaica, Mongolia, and Ukraine appears the most sensitive to a combined GDP growth and exchange rate shock, registering rises in a range of between roughly 4 percentage points and 17 percentage points of GDP.”