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Euro Area Bonds Strong Performers, Though Potential Impact of Central Bank Tapering Looms

Recent Credit Rating Upgraded by S&P Global Lifts Debt of Portugal; Moody’s Upgrades Ireland

The eurozone bond market got a boost in mid-September when Standard & Poor’s Global Ratings upgraded Portugal’s sovereign credit rating to investment-grade status.

The latest news comes amid what has been strong performance in the bonds of so-called peripheral countries and emerging markets within the eurozone and euro area, and upcoming expectations that the European Central Bank (ECB) will begin tapering its bond-buying program, potentially in early 2018.

Portugal had already been considered an investment-grade sovereign credit by Canada’s DBRS credit rating agency. That distinction allowed bonds issued by the Portuguese government to be eligible for the ECB’s bond-buying program as part of the central bank’s quantitative easing measures to inject more liquidity into the eurozone’s financial system.

With S&P Global Ratings’ upgrade of Portugal and early September’s move to a positive outlook from Moody’s Investors Service (though Moody’s still rates Portugal at below investment grade), Portugal’s government bonds may now be more attractive to investors who previously might have passed on the nation’s sovereign debt. That would be welcome sentiment given that the ECB’s bond-buying program has helped compress yields and driven the euro lower.

The total stock effect, or the result of the ECB holding government bond assets on its balance sheet, has been to compress German bond yields by 30 to 40 basis points and the euro’s exchange rate by 7% to 10%, according to data from Oxford Economics cited in this report. The impact, though, has varied by member states with the periphery countries of the euro area benefiting the most from the ECB’s program, Oxford Economics noted.

Without that support, governments like those of Portugal and others like Ireland, Italy and Spain whose bonds were crushed during the sovereign debt crisis could likely face higher borrowing costs. As recently as early March 2012, spreads on Portuguese 10-year government bonds were nearly 1,200 basis points over 10-year German bonds. Since then, they have fallen to 202 basis points over German bonds through Sept. 19. (A basis point is one, one-hundredth of a percentage point.)

During the same period, Irish 10-year bonds have declined from about 520 basis points over German bonds to 28 basis points over. Moody’s upgraded Ireland’s rating to A2 from A3 in mid-September.

Since late July 2012, meanwhile, Italian 10-year bond spreads have fallen by 364 basis points to 166 basis points over German bonds through Sept. 19. Similarly, the spread of Spanish government bonds over 10-year German bonds has declined by about 515 basis points to 111 basis points over bonds.

In addition to ECB support, another factor favoring bonds issued by these countries has been the steady rebound in the eurozone’s economic growth. The eurozone’s economy grew by 2.2% in the second quarter, compared to the same period a year ago, with the Portuguese and Spanish economies growing by 2.8% and 3.1%, respectively.

Low inflation in the eurozone has kept the ECB from fully committing to a tapering program. The central bank, though, is currently on a monthly pace of about €60 billion in net asset purchases, down from about €80 billion in the recent past.

While the ECB’s quantitative easing program has been a factor in lifting economic growth in the eurozone, it has yet to spark inflation near the bank’s 2.0% target. August’s index of consumer prices rose by 1.5%, for example.

One way concerns are being offset about credit spreads potentially unwinding with the withdrawal of the ECB’s monetary stimulus is the suggestion that the ECB could reinvest maturing debt on its balance sheet as it comes due. The ECB could also shift from purchasing fewer government bonds to corporate, agency and other fixed-income securities. That could also address the scarcity of available debt the ECB has recently encountered. Rules have already been loosened, however, that required the ECB’s purchasing of a country’s bonds to be based on a proportion of the size of each country’s economy within the eurozone.


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