Portugal, in our view, offers potential value for investors. As the worst performer in the European government bond markets in the first quarter, it has not been a happy time for those invested in Portuguese government bonds.
While average returns in the euro area in the first quarter were 3.3%, Portugal was in negative territory with -1.3%. By contrast, even Greece managed to post a positive return of 0.4%. As a result of this negative performance, the spread has widened between 10-year Portuguese bonds and 10-year Bunds, which currently stands at around 3%.
There is of course a reason for the poor performance. Portugal had parliamentary elections in late 2015 and political problems have persisted since then. The ongoing political instability is causing nervousness amongst some investors. We don’t see politics as a major issue, in our view the real reason for the weakness is Portugal’s credit rating, or to be more exact, the real reason is one specific credit rating agency.
The only agency that maintains an investment grade rating for Portugal is DBRS, with a stable outlook for the country. This rating is up for a review at the end of April. Should Portugal lose this rating, they would no longer qualify for the ECB’s QE programme. This would of course send Portuguese yields flying like Cristiano Ronaldo after the lightest of tackles near the penalty box. We do not see Portugal’s rating being dropped by DBRS, therefore we do not see Portugal dropping out of the ECB’s QE programme. When this uncertainty around the rating dissipates, we would expect spreads to tighten and for holders of Portuguese government bonds it will be happy days again.
The economic fundamentals in Portugal are rather good: Exports have increased by 30% in the past decade, pushing the trade balance into positive territory. The banks are also in much better shape with core Tier 1 capital in the banking system standing at an average of 12.4% in 2015, compared to 7.4% in 2010. In fact, when it comes to their fiscal budget, Portugal is in better shape than many other countries in Europe. In addition to the positive macro environment, the ECB is buying Portuguese government bonds like a wholesale buyer of Madeira wine being offered a two barrels for the price of one discount. After the announcement in March, the ECB has increased the amount of debt it will buy to a whole one third of outstanding Portuguese debt from April on.
It is due to these reasons that we’re positive on Portuguese debt and believe that as DBRS confirms its stable outlook for Portugal at the end of the month, we could see a significant tightening of spreads. So be prepared for Portugal to pounce.
Ludovic Colin, senior portfolio manager at Vontobel Asset Management
