By Win Thin
There is no real news behind the recent underperformance of Portugal bonds, as it appears that markets are simply getting more nervous as the country’s 10-year yields stay above 7% for the fifth straight day today and for 10 of the last 13 days. We shouldn’t be surprised by this most recent flare up in peripheral tensions, as nothing has fundamentally changed with regards to what we view as unsustainable debt dynamics in much of the periphery. Of course, European officials have promised some sort of significant policy response at the March summit. Color us skeptical. Indeed, the fact the Portuguese bond yields and spreads have resumed climbing after a brief period of stability suggests that the markets are skeptical as well. ECB was rumored to be buying Portuguese bonds today, and would mark the first such activity after two straight weeks of zero bond purchases. Portugal 5-year CDS price rose to 445 bp today, the highest since late January but still below the record high 547 bp back on January 10.
We continue to believe that Portugal will eventually be forced to take an EFSF/IMF package, but that it along with Greece and Ireland will eventually be forced to restructure their debt. After Portugal, it gets a bit trickier. We do think contagion is likely to spread to Spain, but its fundamentals are better than the rest of the periphery and so it is not immediately clear to us that Spain will ultimately suffer the same fate as Greece, Ireland, and possibly Portugal. We created the following chart to give an idea of what fair value should be for euro zone bonds. Yield is graphed against CRI score (derived from our in-house sovereign ratings model), and a fair value line is obtained via regression analysis. Note that Greece, Ireland, and Portugal 10-year bonds are all trading slightly cheap to fair value. However, given the uncertainty surrounding all three, it is clear why investors may be demanding a higher risk premium to hold their bonds.
More interesting is the fact that our model shows Spain, Italy, Belgium, and France 10-year bonds are trading quite rich to fair value. That is, investors appear to be too sanguine about this group given the negative risks that remain in place still. The analysis holds on the shorter end of the curve too (2-, 3-, and 5-year bonds), with Spain, Italy, and France too rich while Belgium is at fair value. Because the ECB bond purchases have led to some distortions in bond yields, we did a similar experiment with euro zone 5-year CDS prices. Here, Greece is rich to fair value, while Ireland, Portugal, and Spain are cheap to fair value. Note too that our sovereign ratings model still points to downward rating pressure for most of the periphery. Rating agencies have been pretty quiet so far this year, but wouldn’t it be great timing for them to announce a big downgrade or two just as markets are getting more nervous?