Rating firms sow doubt on euro-zone bond rally
Euro-zone ratings ‘still at risk’
LONDON: Credit rating firms say they could further downgrade the ratings of highly indebted euro zone countries, putting their bonds at risk of being pitched out of global indexes and reversing a fall in their borrowing costs. The view from the rating firms contrasts with the sanguine attitude of investors who, flush with central bank cash and reassured by the European Central Bank’s promise to take whatever measures are necessary to safeguard the common currency, have been buying lower-rated bonds because of the higher returns or ‘yields’ they earn on them.
On the face of it, conditions for sovereign borrowers in the euro zone are improving. Ireland and Portugal - whose bonds are already rated as ‘junk’, or below investment grade - are gradually emerging from international bailout programs and returning to bond markets for their borrowing needs, while yields on benchmark bonds issued by Spain and Italy, two other countries that have felt the heat of the crisis, have fallen to around 2-1/2 year lows after hitting unsustainable peaks above 7 percent at crisis points last year or the year before.
Analysts say the recent market moves have been because plentiful liquidity provided by the ECB and other major central banks has outweighed unfavorable fundamental factors such as the fact that most euro zone economies continue to contract, while annual budget deficits and public debt levels remain stubbornly high. Ratings agencies warn that may change. “The current favorable market environment is not something that Moody’s is sure will be sustained,” Alastair Wilson, chief EMEA credit policy for the agency said. “The longer the underlying problems - growth, debt, institutions - remain unaddressed, the greater the potential for further shocks.”
Rating firms have a track record of making decisions that at times contrast with the market sentiment. In the past year, Moody’s reaffirmed a negative outlook for the ratings of Ireland, Portugal and Italy, Fitch downgraded Italy, while Standard & Poor’s stripped France of its AAA rating. The most recent example was last month’s downgrade of Slovenia by Moody’s, just before the country avoided a bailout by selling $3.5 billion of bonds in a sale that attracted plentiful buyers.
The downgrade did not cause forced selling of Slovenian bonds as they are not part of major bond indexes, but a similar move on larger countries is likely to be more damaging. Rated only one notch above junk by Moody’s and Standard & Poor’s, Spain is most at risk of forced selling, since some institutional investors only hold investment grade bonds or constituents of investment-grade bond indexes. “They were not at all shy of junking Slovenia, and this could change market perception of how high the bar is to junk Spain,” said David Schnautz, rate strategist at Commerzbank in New York.
Data on how many funds are tracking the bond indexes Spain is part of is not readily available. An exclusion from all indexes could cause 30-40 billion euros of selling - 5-6 percent of outstanding central government debt, JPMorgan estimates. Analysts say domestic banks and foreign hedge funds - using the cheap cash available - are likely to step in and buy the bonds that institutional investors sell, but they would demand more of a premium to hold Spanish bonds over safe-haven German bonds. —Reuters