Risks for the already sluggish performance of emerging debt markets this year are on the rise as liquidity starts to dry up this week, leaving investors warier of risky assets, which have already been shaken up by the U.S. subprime mortgage crisis.

With many investors going on vacation in July, and with a week shortened by the U.S. Independence Day holiday on Wednesday, market liquidity is expected to decrease.

Volatility may increase, and analysts fear the market may not be able to hold a positive performance if the subprime mortgage market continues to provide material for negative headlines.

I don't think the market is going to drop immediately as we start July but there is anxiety about how much more risk tolerance we can see when the external environment for risk is deteriorating, said Enrique Alvarez, Latin America strategist with IDEAglobal in New York.

So I think that is going to make Latin America very dependent on additional noise coming particularly from U.S. credit markets, which is going to be a repetitive theme throughout the rest of the Summer, he added.

Emerging sovereign bond markets closed June with losses of more than 2 percent, their worst performance in 13 months according to the JP Morgan's EMBI+ index. The sell-off slashed emerging debt gains in 2007 to not more than 0.2 percent.

Yield spreads over U.S. Treasury notes, an important measure of risk aversion, soared 10 basis points only on Friday to end June at a three-month high of 175 basis points, the EMBI+ showed.

Despite the sell-off, dedicated emerging markets bond funds had been receiving inflows for 10 consecutive weeks until June 27, according to the most recent data from EPFR Global.

So far, emerging markets have been supported mainly by the performance of investment-grade candidates Brazil and Colombia, which post year-to-date gains of about 3 percent and 4 percent, respectively.

But some analysts fear that, if risk aversion continues to rise, investors will eventually pocket those gains. Others believe, however, that the recent sell-off may be a buying opportunity.

On the second part of the year I expect spreads to return to around 150 (basis points), maybe a little bit tighter depending upon the rating upgrades on benchmark assets, meaning if Brazil becomes investment grade this year or if Colombia becomes an investment grade this year, said Siobhan Morden, a Latin American strategist with ABN AMRO in New York.

The market performance this week will also be dependent on the behavior of U.S. Treasuries and stocks. Yields on the benchmark 10-year Treasuries retreated to near 5 percent on Friday, after a recent spike, as investors rallied to safe-haven assets.

The most important U.S. data affecting markets this week will be Friday's nonfarm payrolls for June, which economists expect to subside after a big increase in May. (Additional reporting by Juliana Siqueira in Sao Paulo)

Investment