Portuguese bonds slide after downgrade

LONDON: Bonds issued by the euro zone's weaker countries came under renewed pressure on Wednesday after Moody's became the first agency to cut Portugal's credit rating to junk, raising fears it would also eventually be pushed into a debt restructuring.

Moody's warned that Portugal may need a second round of rescue funds before it can return to capital markets, citing the risk that private sector creditor participation will be required as a pre-condition.

Portuguese bonds led the peripheral issuers wider with yields on its two-year bonds jumping more than 1.5 percentage points to over 15 percent, with 10-year yields up 72 basis points at 12.90 percent.

"The key worry of the market is that the events that we've seen with Greece are being repeated with Portugal," said WestLB rate strategist Michael Leister.

The cost of insuring against a Portuguese debt default rose to a record high of 850 bps, implying a 53 percent probability of default based on a 40 percent recovery rate, according to Reuters calculations from Markit data.

"The periphery was susceptible to a piece of bad news and we got that last night," said a trader.

"There's probably still enough indexed-linked accounts holding paper that there will be some forced selling because of the junk rating but it's Spain and Italy you need to watch for signs of contagion."

The 10-year Spanish/German government bond yield spread was around 15 bps wider at 264 bps, with 10-year yields at 5.59 percent, back above the 5.5 percent level watched by analysts as a sign of contagion from the euro zone debt crisis.

But Spanish 10-year paper has outperformed its Italian counterpart over the last two weeks with the spread between the two 30 bps tighter although the five-year section of the Spanish curve has come under pressure ahead of an auction on Thursday.

"Spain's five-year bonds have clearly cheapened up on the Spanish curve ... but this hasn't translated into much pressure on Spanish spreads more generally," said Credit Agricole rate strategist Peter Chatwell.

"Adjusted for market direction the Spanish spreads to Italy remain at relatively tight levels for the year. The (Spanish) auctions are slightly smaller in size than the market was expecting, so this has probably helped to keep the market relatively calm."

Commerzbank said that Portugal would drop out of the iBoxx sovereign debt indexes at the end of the month based on an average of the three major ratings agencies.

"The average now comes to 10.67, which is rounded to 11 and thus considered non-investment grade. Thus Portugal will drop out of iBoxx at the end of this month," the bank said.

The bank's strategist David Schnautz said that while markets had been well aware of the risk of a downgrade, the multi-notch downgrade to junk would still trigger forced selling by those that track the iBoxx indexes.

"Obviously the risk has been pending already for quite some time, but at the same time, from anecdotal evidence, secondary market activity has been fairly muted," Schnautz said.

"At the end of the day, even if it's hard to quantify how much, it should trigger some selling.

BUNDS RALLY AHEAD OF 2-YEAR DEBT SALE

Portuguese 10-year bond yields had already risen over 2 percentage points in June, with the country seen as the next most likely to need to restructure its debt if a blueprint is put in place for Greece.

The downgrade is likely to push up Portugal's borrowing costs at a sale of up to 1 billion euros of three-month Treasury bills on Wednesday.

September Bund futures were 69 ticks higher at 126.30 but gains were capped to some extent ahead of Thursday's European Central Bank meeting, where interest rates are fully expected to be hiked to 1.50 percent.

Two-year bond yields were 9 basis points lower at 1.55 percent, with 10-year yields down 6 bps at 2.94 percent.

Against the better demand for safe-haven bonds Germany will sell 4 billion euros of its 1.75 percent June 2013 two-year bonds -- the final reopening of the issue.

Analysts have cautioned the two-year area of the curve does not look particularly attractive given the ECB's expected rate hike and the possibility of more to come.

However, Barclays Capital strategists said the bond does offer value versus surrounding issues on the German curve, while almost 40 billion euros of coupon and redemption payments made on Monday and a cut in third-quarter borrowing of 11 billion euros are likely to support the sale.

Copyright Reuters, 2011