Curmi & Partners

Well Done Portugal

By Matthias Busuttil

Portugal government bonds have been among the top performing euro government bonds, returning approximately 20% on the 7 to 10-year bonds in 2017 and another 1% since the start of the year up until 18th January. On the other hand, pan-euro area 7 to 10-year government bonds returned circa 1% and -0.2% respectively during the same time periods.

What has made these instruments perform so strongly in recent months is essentially the positive underlying economic momentum and fiscal reforms that the country has managed to harness since the European sovereign debt crisis.

Portugal was in the deep end of the sovereign crisis with its 10-year government bond yield spiking as high as 16.4% in January 2012 due to the widespread concerns on the country’s public debt sustainability levels. In order to avoid default, Portugal had requested a EUR 78 billion bailout package by April 2011 from the Troika – the International Monetary Fund, the European Union and the European Financial Stability Facility. The deterioration in Portugal’s credit profile and its banking sector resulted in credit rating downgrades by the three main rating agencies, Fitch, S&P and Moody’s, to BB+, BB and Ba3 respectively between November 2011 and February 2012. The weak economic fundaments had landed Portugal in the group of troubled Eurozone countries tagged as PIIGS alongside Ireland, Italy, Greece and Spain.

In the meantime, the European Central Bank (ECB) had devised the Securities Market Programme (SMP) involving the euro area central banks targeting purchases of selected euro area government bonds, including Portugal, during periods of severe market tension. This programme was aimed at avoiding the rise in yields of selected government bonds from spiraling out of control exacerbating the already precarious debt sustainability situation in these sovereign states.

Later, the ECB also launched its Quantitative Easing (QE) program in 2015, which involves the outright purchases of government bonds across the euro area. The inclusion of Portuguese, Cypriot and Greek government bonds in the program was heavily debated due to their sub-investment grade credit rating and the relatively high perceived credit risk of holding such government bonds on the ECB’s balance sheet. It was ultimately decided by the ECB that the criteria for inclusion of government bonds in the QE program required at least one investment grade rating, i.e. triple-B or better, by any one of the credit rating agencies recognized by the European Commission regulation. Portugal’s only triple-B rating assigned by credit rating agency DBRS has secured the country a spot on the ECB's shopping list.

Since the peak of the crisis, Portugal has been on a recovery path and has seen the implementation of fiscal reforms namely relating to controlling measures on public spending intended to rein in the government deficit as well as the recapitalization of its banks. This is also reflected in improving economic figures reported in Portugal.

The annual GDP growth rate recovered from the low of -4.5% in Q4 2012 to the latest value of 2.5% recorded in Q3 2017. Unemployment has also improved from a peak of 17.5% in Q1 2013 to 8.5% in Q3 2017. Moreover, Portugal’s budget deficit has declined substantially from a high of -11.2% in 2010 to -2% in 2016.

These developments led to the reassessment of the country's credit rating assigned by S&P and Fitch, upgrading Portugal to BBB- in September 2017 and BBB in December 2017 respectively. These upgrades represent an important milestone for Portugal since its government bonds have effectively moved from sub-investment or “junk” bond status to investment grade.

The credit rating upgrades are also increasing the eligibility of Portugal government bonds in government bond market indices.

These factors led to a greater inclusion of Portugal’s government bonds in investment portfolios resulting in a greater demand for these instruments. This is evidenced by the significant tightening in the yield spread between 10-year Portugal and German government bonds trading down from a high of 15.7% in January 2012 to the current level of 1.4%. Portugal has in fact just issued its latest 10-year bond maturing in October 2028 priced at the lowest yield level yet of 2.14% on 17th January.

Further price appreciation emanating from further spread tightening is expected to be very limited. On this basis, the performance of Portugal governments bonds from here on is likely to have a greater dependency on the movements in the general interest rate environment and benchmark bond yields in the euro area as opposed to country specific factors.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.