Market Extra: Portuguese bonds climb in anticipation of ratings upgrade out of ‘junk’ territory

Investors piled into Portuguese debt on Friday on expectation that one of the major ratings agencies would raise its sovereign-debt rating to investment-grade status, and therefore making it eligible for bond benchmark indexes. The move could bring in billions of dollars from investors abroad.

As expected, Fitch did raise Portugal’s credit rating by two notches to BBB from BB+, but didn’t affect bond prices as its decision took place after European trading hours. The move shows the economy’s recovery has made tentative but solid progress after being left in the wilderness of “junk” status, which kept its debt off the books of more conservative money managers and the European Central Bank.

Further buying of Portuguese debt is expected to take place next week.

See: Why Portugal could be Europe’s next economic disaster

The yield for the 10-year Portuguese bond TMBMKPT-10Y, -0.67% or PGBs, slipped to 1.74% earlier in the day from 1.81%, though the dip proved short-lived by the end of the trading session. This temporarily pushed Portugal’s borrowing costs lower than that of Italy TMBMKIT-10Y, +1.27% the largest market for government debt in Europe. Bond prices and yields have an inverse relationship.

Fitch’s decision follows a similar credit upgrade on Sep. 15 by its competitor S&P Global Ratings, the first major ratings firm to lift the country out of “junk.” After S&P initiated the move to investment-grade in Sep. 15, Portuguese bonds rallied, pulling the 10-year yield lower by a whopping 37 basis points to 2.42 percent by the following Monday’s close, according to data from FactSet.

Lower interest rates in Portugal have helped push down the extra compensation, or yield spread, investors receive for buying riskier Portuguese government bonds against its safer German peers TMBMKDE-10Y, -3.12% This so-called credit premium has fallen to 1.50 percentage point for the 10-year maturity on Friday from its 2012 highs of 10 percentage points (see chart lower).

The credit premium for owning Portuguese debt over Germany has been whittled away

That was in part because the nation’s sovereign paper become eligible again for the ECB’s bond buying program, which has driven European interest rates close to zero and negative levels. To qualify for the central bank’s asset purchases, a country has to receive at least one investment grade rating from a major ratings company.

Receiving an additional investment-grade rating from Fitch would qualify Portuguese bonds for key bond indexes, and therefore the billions of dollars linked to these benchmark debt issues. To enter the Barclays Capital Euro Aggregate Index and the Bank of America Merrill Lynch Global Bond Index, a bond must have an average credit rating of investment-grade among the three credit rating firms, including S&P Global, Fitch and Moody’s.

The upgrade represents the latest marker of Portugal’s turnaround as it was seen was one of the hardest hit economies from the eurozone crisis, so much so that it formed a select group of ailing Southern European countries also including Italy, Greece, and Spain.

The Bank of Portugal estimated economic growth for 2017 to hit 2.5 percent, after having expanded 1.4 percent the previous year. And in 2016, it’s budget deficit fell to 2% of its GDP, the lowest level since 1974.

Prior to Fitch’s decision, analysts speculated on how much of an impact the ratings change could have.

Some investors held doubts that the bonds can run up further in price as most of the gains were already captured since S&P’s decision. Nomura Asset Management’s Richard Hodges, said to Bloomberg News, that holders of Portuguese debt should shed some of the assets once Fitch upgraded its debt as there was limited room for price appreciation.

But Elaine Lin and Federico Manicardi, interest-rates strategists at Morgan Stanley, said returning foreign investors could buoy Portuguese paper. Its bond market historically has been dominated by money managers outside its borders.

But since the 2008 financial crisis, the proportion of foreign investment in the overall market has halved to a touch above 40% in 2017 (see chart lower). And of this share, less than 10% of the bonds are held in portfolios outside the eurozone, according to the ECB.

“If Fitch and Moody’s follow suit with S&P in their next rating reviews, more major government bond indices will include PGBs, which is likely to boost non-eurozone investors’ holdings—a supporting factor for the PGB-Bund spread in the medium term, which is likely to force extra tightening, we think, especially given the size of the PGB market,” they wrote.

Foreign holdings of Portuguese government debt have dramatically fallen since the 2007-2009 recession

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