LONDON: Portuguese bond yields headed back towards 3-1/2-year lows on Friday after Standard & Poor's removed the country from credit watch though it kept a negative outlook on its sub-investment grade rating.
The bonds outperformed their euro zone peers again after weakening earlier in the day, even faring better than those of Ireland whose speculative rating or stable outlook Moody's may alter after the market close.
S&P took Portugal's BB rating, which is two notches below investment grade, off credit watch negative, but said there was still roughly a one-in-three chance of a downgrade in 2014.
The fall in Portuguese yields suggests investors are more optimistic than S&P that Portugal can successfully complete its bailout programme later this year and resume regular debt auctions as planned in the first half of 2014.
Sentiment on Portugal has improved due to signs that the economy is recovering from its worst recession since the 1970s, and Lisbon drew good demand at a five-year bond sale last week.
But S&P still saw risks such as lower than expected growth, a slippage in the primary fiscal balance, or the possibility that Portugal's constitutional court might again rule against the government's austerity measures.
Portuguese 10-year bond yields were last 7 basis points down at 5.08 percent, a whisker from 3-1/2 year lows hit on Thursday as investors warmed to Lisbon's plans to return to bond markets and anticipated an S&P move to at least change the outlook to stable.
"S&P shied away from a big decision because of political risks.
But investors are still confident enough in Portugal and what's more important in the short and the medium term is that we've seen that Portugal is able to draw investor demand at bond sales," said DZ Bank strategist Christian Lenk.
Portuguese 10-year yields have fallen about one percentage point since the end of last year, about twice the pace seen in Italy and Spain, albeit from much higher levels.
Portugal's "junk" rating prevents investors that track investment-grade indexes from buying the country's bonds and this is expected to keep its bond yields significantly higher than those in most other euro zone sovereigns.
Lenk and other analysts say the yields could fall back to around 5 percent barring any major political setbacks in coming weeks, against the backdrop of an upbeat global growth outlook that is supporting demand for higher-yielding assets.
"We have more conviction that one should stay long euro sovereign spreads," Morgan Stanley strategists said in a note.
"The macro picture remains supportive, ratings actions have generally been benign, there is positive momentum to the trade and the performance of other risky asset markets," they said, adding they preferred Ireland, Spain and Italy.
YIELD MOMENTUM
S&P also affirmed Slovenia's ratings at A- and Malta at BBB+, both with stable outlooks, while Fitch affirmed the Netherlands at triple-A with a negative outlook.
A calendar of review dates by ratings agencies issued under new European regulations shows Moody's is reviewing its Ba1 rating of Ireland. But it may not issue a statement if it maintains its view, like it did with Portugal last week.
Moody's is the only top ratings agency to rate Ireland below investment grade.
An upgrade would bring Dublin back into JPMorgan's EMU Government Bond Investment Grade Index and prompt investors tracking the index to buy its bonds.
Analysts say the amounts would be small, though, as Irish debt would only have a tiny weight in the index, which is not as widely followed as some others.
It would not make a major difference to investors tracking other indexes, as Irish bond yields are already trading at levels suggesting most investors treat them as investment grade, analysts said.
Irish 10-year bond yields were 3 bps lower at 3.45 percent, below their Italian and Spanish peers.
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