Spanish House of Cartas Grows Weaker

10/12/2012 2:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

The precarious interplay that has allowed Spain to avoid a European bailout looks less and less stable by the day, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Did somebody miss this tiny little detail? And could this detail finally force Spain to ask for a formal program of bond buying—with the loathed “conditions”—from the European Central Bank?

Yesterday, Standard and Poor’s cut its credit rating on Spanish government bonds by two grades to BBB-, just a single notch above junk. Moody’s is currently reviewing its Baa3 rating for a possible downgrade that would take Spain’s rating from the lowest investment grade to junk. Fitch Ratings gives Spanish government debt a BBB rating, or two grades above junk.

A downgrade by S&P, therefore, could move Spain’s average debt rating from investment grade to junk not too far down the road. A junk rating would force some investors to sell their holdings of Spanish government debt. And even the prospect of that downgrade could be enough to trigger selling.

As long as Spanish government debt is rated above investment grade by all three ratings companies, Spanish government bonds remain eligible for inclusion in the Barclays Euro Treasury Index, Markit iBoxx Euro-Area Benchmark indexes, and Citigroup’s European Government Bond Index and World Government Bond Index.

This inclusion is important because some fund managers use these indexes as a guide to allocating their cash. In addition, some funds have guidelines that require them to sell a nation’s bonds if they drop out of an index or lose their investment-grade rating.

Today, the market seems to be saying, “Won’t happen,” since before it did the Spanish government would act to request bond-buying help from the European Central Bank. That belief hasn’t been enough to prevent Spanish two-year notes from falling for a fourth day, the longest stretch of declining prices in six weeks.

But the increase in yields has been modest. Yields on the ten-year bonds remain under 6%, because no one wants to sell these bonds if action by the European Central Bank—which would cause yields to fall and bond prices to rise—is just around the corner.

That’s an inherently unstable position for the market. Spanish bond yields remain low only because the bond market thinks European Central Bank intervention is likely relatively soon. Those low yields mean that pressure on the Spanish government to request a bond-buying program remains muted. Which, in turn, pushes off the bond-buying program that the market is counting on as a reason to hold bonds.

How long will markets wait for Spain to move?

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.

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