Ukraine bonds sink into distress, Russia drops as tensions mount

* Premium on Ukraine over US Treasuries surges past 1,000 bps

* Market pricing in risk of Russian military action

* Bond spreads comparable to when Russia annexed Crimea in 2014

LONDON, Jan 17 (Reuters) - Ukrainian sovereign dollar bonds tumbled into distress territory and Russian bonds suffered sharp falls on Monday as fears of another Russian military foray into Ukraine showed no sign of easing.

The premium investors demand to hold Ukraine bonds over safe-haven U.S. Treasuries as measured by the JPMorgan EMBI Global Diversified index surged past 1,000 basis points for the first time since the COVID-19 pandemic emerged in March 2020.

Less than a dozen countries in the 70-plus strong index have quadruple-digit spreads, including Venezuela, Zambia, Lebanon, Sri Lanka and Ghana which are all either in default or deep debt distress.

"The market has to price in some kind of probability of Russia invading," said Viktor Szabo at asset manager abrdn, noting as well how the concerns had suddenly hit home for investors in recent days.

The United States said last week it feared Russia was preparing a pretext to invade Ukraine if diplomacy fails to meet its objectives, after a massive cyberattack splashed Ukrainian government websites with a warning to "be afraid and expect the worst."

Talks between Moscow and Western states on Russia's deployment of tens of thousands of troops along Ukraine's border had also ended with no breakthrough.

Russia denies it plans to attack Ukraine but says it could take unspecified military action unless its demands - including a promise by the NATO alliance never to admit Ukraine - are met.

SPREADS SOAR

Ukraine's bond spreads, seen as a proxy for such risks, have already more than doubled since November and are now at levels last seen at the height of the March 2020 COVID-19 market rout.

They are also broadly comparable to levels hit when Russia invaded and then annexed Crimea in March 2014, although spreads then blew above 4,000 bps in early 2015 when Kyiv was tipped into default in the resulting turmoil.

Monday's sell-off saw Ukraine's bonds continue to fall on international debt markets. Some were down more than 3 cents on the day at nearly 80 cents in the dollar having been at 100 cents just over a month ago.

Many issues also saw bid-ask spreads widen to well over one cent, indicating that traders were having difficulty offloading their bonds.

"Ukraine has probably lost market access, and this could complicate financing plans this year, if sustained," said Stuart Culverhouse at Tellimer.

Last month the head of Ukraine's debt management department told Reuters the country was hoping to wait out the current tensions. It will need money at some point though with a $1 billion refinancing deadline in September.

Russian sovereign bonds also felt the pain. Yields on Russia's 10-year benchmark OFZ government bonds hit their highest since April 2016 at 9.5%. Refinitiv data also showed the country's 2043-maturing dollar-denominated bond tumbling more than 5 cents at one point and again many of the bonds hit their lowest since 2020's pandemic rout.

Russian spreads over U.S. Treasuries widened as far as 238 bps on the day which left them 71 bps up this year. The moves were then pruned slightly after German newspaper Handelsblatt reported that Western governments had taken the option of cutting Russian banks off from the crucial Swift global payment system off the table.

The rouble also edged higher on that speculation, but 5-year credit default swaps (CDS) for both countries rose again, too. Ukraine's CDS which investors use to hedge their risk were up 76 basis points from Friday close at 918 bps, data from IHS Markit showed. Russia's jumped by 34 bps to 215 bps.

Veteran Ukraine and Russia watcher at BlueBay Asset Management Tim Ash called it a "strange day" when markets had suddenly woken up to the risks of the situation.

(Reporting by Karin Strohecker and Marc Jones; Editing by Toby Chopra and Hugh Lawson)