As a direct consequence of Moody’s downgrade of Portugal to sub investment grade, now Ba2 to be precise, Portuguese corporate bonds will be removed at month end from Bank of America Merrill Lynch’s (BofAML) main investment grade and high yield indices. This is because the main BofAML indices require the sovereign to have an investment grade rating. (It also looks as if Portuguese corporates will be thrown out of the iBoxx indices, although we don’t have confirmation on this yet). This will affect bonds issued by the likes of Portugal Telecom (PT) and Energias de Portugal (EDP – the electric utility) despite their current investment grade ratings. Those bonds are set to enter the BofAML Global Emerging Markets Credit indices.
Whilst some index focussed investors will be permitted to hold off -index positions, many will be forced to sell out over time, putting further upward pressure on bond yields. Since the start of the year, yields on EDP and PT 8 & 9 year bonds have risen by almost 2% to 7.5% & 8.75% currently.
Given the size of the Portuguese economy its corporates have historically constituted a small portion of broader Euro corporate indices (the same can be said for Greece and Ireland). As of yesterday’s close, Portuguese corporates comprised only 1.1% of the BofAML EMU Corporate Index. However, given the larger size of the Spanish and Italian economies it isn’t surprising to see their corporate bonds form a significant 14% of the index. And whilst Spanish & Italian government bonds currently remain firmly in IG territory, further downward pressure on those sovereign ratings will undoubtedly leave investors in peripheral European credit increasingly nervous.