Portugal under pressure, but default unlikely

@CNNMoneyInvest January 26, 2012: 2:40 PM ET
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NEW YORK (CNNMoney) -- Portugal has come under heavy pressure in the bond market this week as investors fear the nation could be the next domino to fall in the eurozone debt crisis.

On Thursday, the yield on 10-year government bonds spiked above 15%, the highest level since the euro currency was launched in 1999, while yields on 3-year notes surged to nearly 21%.

Investors have been rattled by the increasingly coercive debt negotiations in Greece, where private sector bondholders are facing losses of up to 70% of their Greek debt holdings. The fear is that Portugal may eventually seek a similar deal to write down some of its €162 billion debt load.

Portugal's borrowing costs shot up after Standard & Poor's downgraded the government's credit rating to speculative grade, or junk, on Jan 13. The ratings agency said investors could lose up to 50% of their holdings if Portugal were to default on its debts.

But investors are also worried about Portugal's bleak economic prospects and the uncertain outlook for the eurozone in general. The Portuguese economy is expected to shrink 3% this year as austerity measures take their toll and the broader eurozone economy contracts.

"Obviously it is not just the downgrade but the starting debt position, the economic outlook and the possibility that Greece is setting a template for the future that is concerning investors," said Gary Jenkins, a fixed-income analyst at Swordfish Research.

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While the bond market has turned against Portugal, investors have been primarily worried about larger eurozone economies such as Italy and Spain, which are seen as vulnerable to a full-blown debt contagion.

Borrowing costs for Italy and Spain have backed off recent highs amid a flood of liquidity from the European Central Bank, which pumped nearly €500 billion of long-term loans into the banking system and relaxed its collateral requirements.

Meanwhile, Portugal succumbed to the debt crisis long ago. The nation first tapped a €78 billion bailout from the European Union and International Monetary Fund in Apirl 2011.

In December, the IMF released €2.3 billion from Portugal's bailout and praised the government for the progress it has made on fiscal reforms, saying the program was "broadly on track."

The IMF expects Portugal to return to the public markets in 2013. But fund officials cautioned that the government needs to do a better job at controlling public spending, especially at the local level and in state-owned enterprises.

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Despite the market pressure and economic challenges, analysts say Portugal is not in immediate danger of default.

"Regardless of the future complications, it is unlikely that the government will opt to default in the next few months," said Antonio Barroso, an analyst at Eurasia Group, a political risk research firm.

However, the government may need to seek additional bailout money in the second half of the year, depending on its progress on fiscal reforms and the outcome of the eurozone crisis, Barroso wrote in a note to clients.

Greece, by contrast, has struggled to implement budget cuts and structural reforms that are a condition of its bailout loans.

The nation has yet to seal a deal with private investors over a proposed 50% reduction in the value of Greek government bonds. The agreement is a key condition of a second €130 billion bailout, the terms of which are now being negotiated.

Athens is facing a €14.5 bond redemption in March that it may not be able to pay without additional bailout funds.

Ireland, which passed its latest bailout review with flying colors last week, has been the most successful bailout recipient. The nation's borrowing costs have eased this year and Dublin announced a debt swap with private investors on Wednesday.  To top of page

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