Rating cuts would hurt Spain more than Portugal

By Marius Zaharia

LONDON (Reuters) – A Spanish ratings cut may hit government bond markets harder than the recent salvo of downgrades on Portugal because, unlike its neighbor, Spain is seen capable of escaping without an international bailout.

Fitch gradually slashed Portugal’s sovereign credit rating by five notches over the two weeks after the Portuguese government collapsed on March 23. Other agencies downgraded Portugal but the market reaction was muted, raising questions over whether the ratings firms are behind the curve.

But analysts caution that Spain is in a wholly different position and that a change in the external view of its creditworthiness would have a negative impact.

Portuguese bond yields have hit record highs daily in recent weeks, but the spike that often follows a downgrade was absent. Recent Irish and Greek ratings cuts were also largely ignored.

The main reason for this muted reaction was that markets were already treating Irish, Portuguese and Greek bonds as junk. That does not apply to Spain, which has been fighting to distance itself from the three countries so far that have sought bailouts and has retained higher credit ratings.

Marc Ostwald, strategist at Monument Securities said that at the time of the recent downgrades markets were pricing in a bailout for Portugal and some possibility that Greek and Irish debt would eventually have to be restructured.

“But another Spanish downgrade within the next four to six weeks would not be something that the market is factoring in. If Spain were to be downgraded it would almost certainly renew contagion fears … and the fact they may still be A+ (potentially after a downgrade) is not necessarily a shield.”

Spain is rated AA+ by Fitch, one notch above the Aa2 rating by Moody’s and AA by Standard & Poor’s. Although its bond yields are some 40 basis points higher than Italy’s, Spain is still rated two notches higher that Italy by two of the firms.

That is more likely to mean Spain’s ratings have room to fall and yields to rise than the opposite. When Portugal was rated the same as Ireland by S&P about two weeks ago, its yields were 200-300 basis points lower than Ireland’s.

Portugal is now rated two notches below Ireland by two of the agencies and the yield spread between the two has since tightened to about 70 basis points, with some room still to go.

Gary Jenkins, head of fixed income at Evolution Securities, said markets charge Spain more than Italy to borrow, due to a ‘perhaps unfair’ comparison with Ireland, which has also gone through a property market-driven credit boom and bust — unlike Italy and Portugal.

“Even though Italy has a huge amount of debt outstanding, they didn’t have the same problems with the banking sector so the market looks slightly more favorably upon the likes of Italy,” Jenkins said.

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All three major agencies have Spain on a negative outlook, so markets should normally not be surprised by a downgrade. But analysts say that as long as ratings agencies are not perceived as way behind the market, there is an almost Pavlovian reaction to downgrades.

“If Spain were to be downgraded, the market would fear that it is just the beginning of further downgrades,” said Niels From, chief analyst at Nordea.

Some investors — swayed by a European Union pledge to raise the size of the euro zone rescue fund so that it could cover a potential Spanish bailout — placed bets that Spain could avoid its neighbor’s fate by buying its government bonds.

This has driven a tightening of 10-year bond yield spread over benchmark German Bunds by some 50 basis points from a two-month peak on March 10 of 232 bps, levels to which it was pushed by a Moody’s downgrade.

That move proves investors give Spain a chance of not following in the steps of Portugal, Greece and Ireland as long as it sticks to its reform pledges. Failure to do so could see spreads widen again very quickly, analysts say.

Russell Silberston, head of global interest rates at Investec Asset Management, which manages fixed income assets worth $29 billion, said he was waiting for “clear progress in deficit reduction” before he takes on exposure to Spain again.

“While we just wouldn’t think about Greece and Ireland and Portugal, for Spain we have contacts there, we speak to companies and investors,” he said. “(But) we are just looking more closely, we haven’t bought it yet.”

Rating cuts would hurt Spain more than Portugal