* Fears of a downgrade ease after budget, bad bank proposal
* DBRS to assess Lisbon's last investment-grade rating
* Eligibility for ECB bond-buying in the balance
(Updates prices for close)
By Abhinav Ramnarayan
LONDON, Oct 18 Portugal's government bond yields
hit their lowest level in nearly five weeks on Tuesday ahead of
a crucial ratings review from DBRS this week.
Portugal on Friday slashed its deficit target for 2017 to
1.6 percent of economic output from this year's estimated 2.4
percent, and a report from German newspaper
Handelsblatt revived suggestions Lisbon is planning to set up a
bad bank to deal with the struggling banking sector.
Those two developments strengthened expectations that DBRS
would leave the country's last investment grade rating untouched
at a scheduled review this Friday.
Concerns over the rating - with eligibility for the European
Central Bank's asset purchase programme in the balance - has
weighed on Portugal's government bonds since
"I think the market now believes the investment grade rating
should survive, and we tend to that view as well," said
Commerzbank rates strategist David Schnautz. "It remains to be
seen if this is just a feel good environment or if it is
He sounded a note of caution, saying that it remains to be
seen if the deficit target - part of the draft budget proposal
for 2017 - proves feasible.
Portugal's 10-year bond yields rose nearly a full percentage
point from 2.69 percent on Aug. 15 up to 3.63 percent last
Monday, Oct. 10. Since then, government comments suggesting the
rating was safe and further good news have pushed yields lower.
On Tuesday, the yield on the Portugal 10-year benchmark
fell 2 basis points to 3.25 percent, its lowest
since Sept. 13.
One of DBRS's key concerns has been the Portuguese banking
sector, and Handelsblatt reported on Monday the government is
planning to create a bad bank to absorb the non-performing loans
(NPLs) that have plagued its financial institutions.
Prime Minister Antonio Costa said in April that the country
needs to work with regulators to find a solution for the banking
sector's non-performing loans and named a fund for bad loans as
a possible option. Sources say there have been no concrete
developments on that front so far.
"This is a reminder that there are issues for Portugal
beyond Friday's review, and NPLs are a very difficult beast to
tackle," said Schnautz. "Though the mechanics of the bad bank
are still unclear, at the very least they are dealing with issue
The yields on other euro zone government bonds were slightly
lower on the day, hauled down by UK government bond yields which
clawed back some ground on suggestions that its parliament will
have to ratify a British deal to leave the European Union.
The yield on 10-year gilts fell as much as 6 bps to 1.07
percent, and Germany's 10-year Bund, the euro zone's benchmark,
was down 2 bps to 0.04 percent.
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(Reporting by Abhinav Ramnarayan; Additional reporting by John
Geddie; Editing by Alison Williams and Raissa Kasolowsky)