Prices of peripheral bonds in Europe bounced on Monday, led by Portugal and Ireland riding high on the back of their credit ratings upgrades last Friday, as analysts questioned how much more steam the rally had left in it.

By 2 p.m. London time on Monday, the spread between 10-year Portuguese debt and its German equivalent had narrowed to 208 basis points while the spread for Irish bonds of the same maturity had been whittled down to a mere 29 basis points. During the euro zone crisis in 2012, the spreads on both had temporarily widened out to well over 1,000 points.

Following the close of markets on Friday, S&P upgraded Portugal by one notch to BBB- which has the significance of returning the country’s debt to investment grade status in the eyes of this credit rating agency.

Yet Monday’s sharp move tighter in Portugal’s bonds is unjustified by the technicals of the situation, according to Richard McGuire, head of rates strategy at Rabobank, who says there should be no “mechanically positive impact” from the push back into investment grade territory.

“Portugal is already rated as investment grade by DBRS (another ratings agency) which means that Portuguese collateral was already eligible to be pledged at the European Central Bank (ECB),” McGuire explained in research sent to clients on Monday, noting that the upgrade will also not change the ranking of Portuguese government bonds in the ECB’s framework.

“Second, we do not expect S&P’s upgrade to have an immediate impact on Portugal’s potential inclusion in investment grade benchmark indices as eligibility for these tends to be based upon the average rating of the big three or the middle rating,” he added, before turning to what he described as the “tapering-shaped elephant in the room”.

“We expect the ECB to begin winding down the quantitative easing (QE) programme in January next year which is precisely the same moment one might expect the country to re-enter investment-grade benchmark indices…it would appear that much of the good news of a further upgrade is already priced while the potential bearish impact of tapering has yet to be fully discounted,” the strategist concluded.

Yet, not all analysts share the same degree of caution with regards to the possible fallout for yields of peripheral European countries (Portugal, Ireland, Italy, Greece and Spain) from a pullback in the ECB’s existing ultra loose monetary policy regime.

“Even with lower monthly purchases the ECB will, in our view, be keen to manage the transition away from QE by changing the design of its purchases. In particular, we think there are many advantages in buying less government bonds and more corporate, covered, agencies and supranational bonds,” posited Antoine Bouvet, vice president in rates strategy at Mizuho, via email on Monday.

“This would help the ECB to prevent credit spreads from widening as it reduces its purchases. This is the reason why we are expecting the impact on peripheral spreads to be limited,” he added, referring to his expectations for the credit spread – or the gap representing the perceived riskiness of peripheral debt compared to German debt – once the central bank begins its highly anticipated tapering programme.

Moreover, European bond yields overall shouldn’t suffer too greatly once the withdrawal of monetary stimulus begins, according to Jack Allen, European economist at Capital Economics.

“We think that corporate bond yields will rise only gradually as the ECB tapers its asset purchases next year. After all, the economy looks set to continue performing well,” he argued in a note to clients on Monday.

“And the Bank is likely to keep enough flexibility in the programme to increase corporate bond purchases again, if needed,” he concluded.

Source: cnbc
Bond markets in Europe rally after ratings upgrades — but analysts ask if it can last