Hungary's borrowing costs may rise the most in almost three years after a credit rating downgrade, an increase in the nation's budget deficit and an interest-rate boost by the central bank. The yield on benchmark five-year bonds climbed 1.57 percentage points to 8.42% last month, the biggest increase since 2003. The jump means Hungary will pay Ft 707 million ($3.2 million) more in annual interest on notes it sells this week than in a bond auction last month. Hungary is struggling with rising interest costs as it attempts to reduce this year's record Ft 1.8 trillion budget deficit. The increase is a disappointment from last year, when demand from investors drawn to the highest yields in the European Union pushed five-year bond yields as low as 5.41% in September. “Hungary is getting punished as it should be,'' said Guillaume Salomon, a fixed-income strategist at TD Securities in London. “The market is getting increasingly frustrated by promises of an improvement in the budget, which is not coming through. Hungary is going to continue suffering.'' Concern the deficit will be wider than forecast by the government contributed to a 4.89% slump in Hungarian bonds during June, the worst among 26 debt markets tracked by JPMorgan & Co.'s Global Government Bond Plus Index. The bonds have also been hurt by a sell-off in emerging-market securities that started in May. Developing-country debt issued in local currency has tumbled 5% since hitting a high on May 10, according to JPMorgan's Emerging Local Markets Plus Index. Foreign investors own more than 40% of Hungary's Ft 6.5 trillion of bonds outstanding. The Ft 45 billion offering of 6% bonds due 2011 is the first sale of five-year debt since Standard & Poor's lowered Hungary's rating one step to BBB+ and the central bank boosted its benchmark rate for the first time in 2 1/2 years. The sale is scheduled for July 6. “The question is whether yields are high enough'' to satisfy investors, said Franz Schardax, a fund manager at Capital Invest in Vienna who cut his holdings in Hungarian debt last month. Schardax, who helps manage $490 million, doesn't plan to buy the bonds being auctioned. Demand for Hungarian debt is dwindling as concern mounts the government will miss economic targets for a fifth year.Investors on average have placed bids worth 1.55 times the amounts sold at five-year debt auctions this year, down from 2.39 in 2005. The finance ministry probably will fail to get enough bids to sell all the bonds, forcing it to scale back the offering for the first time since 2004, said Illés Tóth, an emerging-markets bond and currency strategist in Budapest at DZ Bank AG, Germany's sixth-biggest bank by assets. The ministry also plans to sell Ft 40 billion of 5.5% bonds due February 2016 this week. Ten-year yields have risen to 8% from 6.77% at last month's auction. Prime Minister Ferenc Gyurcsány's government announced a deficit-reduction plan on June 10 that included raising taxes, eliminating government jobs and abolishing subsidies for energy prices. Five days later, S&P cut its local-currency debt rating for Hungary to three steps above junk status, the lowest ever. S&P analysts predict the deficit will soar to 11% of gross domestic product this year, compared with the government's 8% estimate. “Cuts in spending are not high up on the government's agenda,'' Kai Stukenbrock, a credit analyst at S&P in London, said in an interview last week. “This program is not even enough to compensate for the worsening of the situation.'' Hungary will have to increase the amount it raises from forint-denominated bonds this year after the government lifted its deficit forecast to a record 1.8 trillion last month, said Schardax. The increase in Hungarian debt yields may attract some investors, said Lars Christensen, an emerging-markets strategist at Danske Bank A/S in Copenhagen. “After successive governments have disappointed, it seems that finally we have a government that's willing to do something about the fiscal deficit,'' said Christensen, who recommended buying the bonds that are being sold. “Hungary may prove to be one of the turnaround stories.'' Investors deserted emerging markets in May after the U.S. raised interest rates and on concern other central banks would follow. Sixteen central banks boosted borrowing costs last month, reducing the attractiveness of debt sold by developing countries. The 10-year bonds that are more sensitive to inflation have lost investors Ft 55.9 million for each 1 billion forint invested since interest payments began accruing in October. “Investors are going to continue to avoid Hungarian bonds,'' said Koon Chow, an emerging-markets strategist at Credit Suisse Group in London.