Friday the 13th may be an unlucky omen for Portugal. On that day, almost two weeks ago, Standard & Poor’s became the last rating agency to downgrade Lisbon to junk, marking the moment for many investors when default looked inevitable for Portugal as well as Greece. As the rating agency’s action prompted forced selling by funds not allowed to hold junk-grade bonds, other investors joined the exodus as views hardened that Portugal was heading towards a similar fate to Greece, which is expected to default imminently.More selling was then sparked by Portugal’s removal from Citigroup’s European Bond index, which many investors track, because of its fall to junk status. The other main credit rating agencies, Moody’s and Fitch, downgraded Portugal to junk last year. In the eurozone, only Greece is also rated junk by all the main agencies.
John Stopford, head of fixed income at Investec Asset Management, says: “S&P’s action was important. Once a country is downgraded to junk, it is hard to see an easy way back into the markets – and Portugal is running out of time. It is supposed to access the bond markets again next year.”
More critically, the fear is that should Portugal follow Greece, it could spark default contagion to the bigger, more strategically important economies of Italy and Spain, which in turn would reignite fears of a eurozone break-up that undermined the markets at the end of last year.
Certainly, the markets are pricing in a Portuguese default with 10-year bonds trading at about 50 per cent of par, a deeply distressed level in the eyes of many investors.
Portugal is also the only peripheral eurozone bond market that has failed to rally since the European Central Bank announced plans to offer three-year loans to the eurozone’s banks on December 8, a move that averted a credit crunch.
Since then, Portuguese five-year yields, which have an inverse relationship to prices, have jumped 268 basis points to euro-era highs of 18.71 per cent. In contrast, the other peripheral nations have seen sharp falls, with Irish yields plunging 265bp to 6.08 per cent, helped by Dublin hitting its fiscal targets and bringing down its budget deficit.
“Portugal’s bond market stands out like a sore thumb,” says one investor. “This is because there is a growing conviction that Portugal, despite its better fundamentals than Greece, will end up like Athens and have to negotiate some kind of restructuring with private investors.”
Luigi Speranza, an economist with BNP Paribas, says: “There is a clear funding gap and it’s justifiable from an economic point of view to doubt that Portugal will be able to access the markets next year.”
Under the terms of its €78bn rescue programme, Portugal is required to return to the markets to raise medium- and long-term finance by May 2013, five months before a €9bn debt repayment falls due.
Whether Portugal will require a Greek-style debt restructuring involving private sector investors, however, is ultimately a political question that will be decided by EU leaders, say strategists.
António Saraiva, head of the Confederation of Portuguese Industry, said on Wednesday that he was hopeful that Portugal’s rescue package could be expanded by about €30bn without involving private investors.
However, Pedro Passos Coelho, prime minister, has ruled out any change in the terms of the rescue package. “We will not ask for more time or more money,” he said this week. “We will not seek to renegotiate the programme.”He realises that default would put big strains on the economy. “The costs to a country of a sovereign default are high,” says Antonio Garcia Pascual, chief southern European economist with Barclays Capital. “A government would not voluntarily request a bondholders’ haircut. It would be a solution of last resort.”
Portugal’s economy is in much better shape than that of Greece, and has a much lower debt burden. Lisbon’s debt to gross domestic product ratio is forecast to rise to 111.8 per cent in 2012 by the International Monetary Fund compared with a level for Athens of 189.1 per cent.
There is also a significant difference between the two countries in market terms. Greek five-year bond yields trade 33.26 percentage points higher than Portugal’s at 51.31 per cent. Athens sovereign CDS is pricing the chance of default in the next five years at 90 per cent, much higher than Portugal’s 68 per cent.
Yet it was only nine months ago that Greek bond yields and CDS prices were at the levels of Portugal today. And at that time, worries over default for Greece jumped sharply as investors and even one of the economic advisers of Angela Merkel, German chancellor, warned that Athens would inevitably need to restructure its debt and end up defaulting.
Mr Stopford says: “Once the markets start to fret over default, then it can be hard to stabilise or stop yields from rising. Portugal looks more and more like it will follow Greece. And it can be self-perpetuating. It is only domestic investors that seem prepared to buy Portugal.”
Indeed, for many investors, the debate has moved beyond whether Portugal will default to a graver theme. “Portugal is a diddy, diddy country, but these little countries can cause contagion and increase default risk to the bigger economies. In such a scenario, worries about euro break-up will quickly return to the fore,” says another investor.