The expected launch next week of a new 10-year benchmark bond by Portugal, whose credit rating was recently downgraded by Standard & Poor’s, is set to test investors’ appetite for debt issued by weaker eurozone members.
Portugal, which on Friday appointed bankers to manage the syndicated bond sale, will be competing for demand against France, which enjoys the highest credit rating available and plans to auction a new 10-year bond of its own next week.
“If it is a head-on competition between French and Portuguese paper, I don’t think that the Portuguese will win in the long-run,” said Wee-Khoon Chong, European rates strategist at RBS Financial Markets.
Amid concerns about Portugal’s deteroriating public finances, S&P cut the country’s long-term rating from AA to AA-. Fitch Ratings followed by reducing the rating outlooks for both Portugal and Italy to negative.
Bond spreads of Portugal, Italy and Greece - the three weakest countries in the eurozone - widened marginally on the back of this. On the week, the spreads of bonds of Portugal, Italy and Greece, widened by just 1.3bp, 0.5bp, and 0.5bp, to stand at 8.3bp, 21.5bp, and 24.5bp, respectively against Bunds.
But they have been widening for several months. Spreads of Italian 10-year paper, for instance, have doubled from 11bp to 21.5bp against the Bund in the last four months.
This is significant because investors are demanding more of a premium for buying debt issued by weaker members even though this directly challenges the theory behind the creation of the eurozone, namely that the debt behind all of its members should be treated equally.
“If spreads continue to widen [against German Bunds], then it would be better to hold onto French debt,” said Mr Chong. But Marc Ostwald, analyst at Monument Securities, pointed out: “Until we actually stop this desperate search for yields, it is very difficult to push the spreads out.”
Indeed, sustained appetite for government paper pushed eurozone yields to 3.1 per cent earlier this week. Persistent evidence of sluggish growth and speculation about an interest rate cut have helped push yields lower.
While some stronger than expected data this week has helped dampen such speculation in the eurozone, the market has now almost fully priced in an interest rate cut of 25bp for the UK as early as August. Gilt prices rallied sharply this week before losing some ground on Friday when 10-year gilt yields .
But neither the European Central Bank or the Bank of England are expected to slash rates when their respective interest-rate setting committees meet next week. Across the Atlantic, however, the Open Market Committee of the US Federal Reserve, as expected, raised interest rates by another 25bp to 3.25 per cent late Thursday.
