Portugal’s bond suggests a rehabilitated state

Euromoney, June 2013

In early May, Portugal took to the bond markets in style. It raised Eu3 billion in 10-year funding in a deal that attracted a Eu10 billion-plus book from 369 investors, and did so at almost the same spread it had paid for five-year funds a couple of months earlier. “That’s quite a statement,” says PJ Bye, global head of public sector debt syndicate at HSBC, one of the leads on the deal.

So is that it? Portugal rehabilitated in the eyes of the world’s investors, with ready access to funding, over the worst and ready to rebuild? The bond is unquestionably good news and a very clear vote of confidence, but Portugal remains a sub-investment grade developed-world economy with precious little growth and a troubled banking sector. Progress has been made, but there are plenty more hurdles ahead.

The bond issue was highly significant, and not just because of the money. Although Portugal had tested the waters with a tap of an existing deal in January, this was the first new government bond issue since the country requested an international bailout two years ago. That Eu78 billion bailout was a three-year program from which Portugal is due to exit in June 2014, and a condition of its exit – which will be a milestone for Portugal – is that the country demonstrates it has regained full market access. That is the point, more than the cash: Portugal had already met its financing needs for 2013 and was pre-financing next year.

The deal, which tapped a far wider investor base than the hedge fund-heavy subscriptions to the earlier tap, appears to have demonstrated market access rather well. “The notable thing about the transaction was not necessarily the book size, but the number of accounts,” says Bye. “There are more people playing now than there were earlier in the year. And in that earlier deal, it was a large book, but something like 25% of it was from the hedge fund community rather than the traditional, buy and hold rates investor base.” Those close to the deal say this time around, hedge funds took 7%.

There was a greater geographical spread, too. “We saw demand from jurisdictions that are usually known as being more conservative, like Scandinavia and France,” says Paulo Pinto, head of debt capital markets at Caixa Banco de Investimento, another lead manager. “We also saw demand from Spain. The broadening of the investor base was substantial.” And it has tightened in the aftermarket too, by 15 basis points at the time of writing.

Yet not everyone has been quite so quick to applaud. Asked if she thinks the deal shows Portugal has regained full market access, Kristin Lindow, senior vice president at Moody’s, says: “My answer would be: not yet. Although market access is clearly established, full market access suggests issuance at will, on the basis that Portugal enjoyed prior to the bailout.” On this reading, the issue worked because of its high yield – around 5.7%, far higher than most major debt-issuing markets – and because of the improving sentiment around the Eurozone itself and its support of peripheral nations, rather than because of the inherent strength of Portugal. That’s not quite the same, says Lindow, as “leaving the bailout program with no worries about new financing and refinancings.” But, as Lindow points out, “this question of market access is criteria the troika [the European Commission, European Central Bank and International Monetary Fund, who collectively organised the bailout] has laid down. The determination lies with them, not so much with us, as to whether Portugal has full market access.”

Others feel the Portuguese have done enough to say they’re regained market access. “I think they have,” says Bye. “If you can issue a long 10 year bond and generate Eu10 billion of demand at a tight spread to where your bonds are trading, then you have found a market-clearing level for benchmark-size issues.” Perhaps Portugal needs to launch another auction to demonstrate truly full market access. “But in a way, auctions are easier than syndications: they tend to be smaller, and primary dealers tend to support them through good or bad,” Bye says. Pinto at Caixa, who works closely with Portugal’s IGCP debt management office, believes an auction will come next in order to boost liquidity.

In any event, the return of asset managers – who made up 51% of the deal’s distribution – is welcome. “Portugal is in an odd situation, in the sense that it is a mature economy with the rating of an emerging market, so it doesn’t fit well with the profile of many investors,” says Rui Antonio Constantino, chief economist at Santander Totta in Lisbon. “Now you are seeing some investors come back to Portugal despite the rating, and that is an important step – also for other Portuguese issuers going back to the market.”

To an extent, Portugal has clearly caught the rising wave of investor sentiment towards the Eurozone more broadly, which – leaving aside the wobbles around Cyprus – has improved steadily ever since Mario Draghi, European Central Bank president, pledged last year to do “whatever it takes” to save the euro. In this respect, the deal fits into the same context as Ireland’s Eu5 billion bond, also 10-years and also heavily oversubscribed, in March.

But what about the country’s own fundamentals? Here, there is good and bad.

On the good side, the government has made fiscal and structural reform, from labour legislation to industrial licensing to the court system. “Despite all the difficulties in the economy, there has been significant fiscal progress, particularly in the primary deficit,” says Constantino. “It’s not relevant whether cuts are $4 billion or $2 billion; the important thing is you have a credible program which can be implemented and which will bring permanent savings going forward. A significant step has been taken in reducing expenditure.”

Even Moody’s, the most bearish of the agencies, with a negative outlook on the already sub-investment grade Ba3 (equivalent to BB) rating, has positive things to say on this. “Portugal has established an attractive profile,” says Lindow. “It has been willing to undertake structural reform without being coerced into doing so. It has met the fiscal criteria of the program – and where there has been some loosening in those criteria, it’s not because of government slippages or overruns in spending but cyclical reasons. And investors have seen an enormous decline in yields.”

There is plenty on the negative side too, however. None of its numbers are particularly alluring: government debt was equivalent to 123% of GDP at the end of 2012 and hasn’t moved much since; the government is targeting a deficit of 5.5% of GDP in 2013, worse than previous expectations; and economists are typically calling a 2% shrinkage of the economy in 2013, before exceptionally modest growth – perhaps 0.5% – next year.

Then there have been other challenges. In April, a court in Portugal ruled that planned government austerity measures were in breach of the national constitution. Subsequently, prime minister Pedro Passos Coelho announced Eu4.8 billion in public spending cuts over the next three years, partly to replace the cuts that the court had rejected. But the measures have already been denounced by unions, and the issue demonstrates the difficulty in getting unpopular decisions, vital to the terms of the bailout, through in a country whose population is exhausted by recession.

Banks, in particular, face headwinds. Moody’s has had a negative outlook on Portugal’s banks since 2008, and expects the outlook to remain negative for at least the next 12 to 18 months. “Underpinning this view is the very weak underlying conditions for Portuguese banks, because of the weak economic situation in the country,” says Pepa Mori, senior analyst at Moody’s. She says earnings generation will be affected by the declining economy, NPLs will accelerate, and recurrent revenue sources will decline.

The recent interest rate cut from the ECB didn’t help. “That affects the banks, especially those that have sizeable mortgage portfolios.” As for funding, some banks did manage to return to the capital markets in late 2012, having been absent since mid-2010. “But from our point of view, the situation is far from having normalised. In the past Portuguese banks had significant reliance on wholesale funding.” All banks in Portugal are amid deleveraging plans, improving their funding profile, but still, the outlook is not good.

“Banks are recapitalised and able to fund themselves through the ECB,” adds Constantino. “But we need to see if the economic recession continues: then you have unemployment picking up, impairment provisions and problems with profitability.” Mortgages in Portugal are floating rate and the average spread for a mortgage book is 100 basis points, he says, meaning the ever-lower interest rates have two consequences: one, people can still repay their mortgages, so delinquency rates have not increased notably; but two, “what the banks are making on their mortgage book is less than their cost of funding.”

Andres Rodrigues, banking sector analyst at Caixa, takes a slightly brighter view, given the progress that has been made in improving capital ratios since 2007, to an average of around 10% today – likely well in excess of any banking regulation that might come Portugal’s way. “Banks are much more sound than they were four years ago,” he says. Liquidity has improved too, and the sovereign bond may do the sector a favour in funding. “Slowly but consistently, it makes sense to believe Portuguese banks can re-open the market after the Republic.” And deposits have been resilient. “The issue is on asset quality, which is linked to forecasts for GDP in Portugal,” he says. He expects a peak in NPLs in early 2014 for most banks, after which the economy may be brighter and there may be hopes for growth. “The fact is, you will only improve the profitability of the banking system in a sustainable way by improving net interest income and reducing loan provisions.”

Events to watch for in the year ahead are – like the rest of Europe – the German election, and then locally the Portuguese state budget for 2014, which will come at the same time Portugal begins looking at local elections. “We will see some stress points,” says Constantino. “But the political will, domestically and externally, will be to avoid problems from escalating.”