Portuguese covered bonds are at risk of being downgraded after Moody’s yesterday (Tuesday) lowered the country’s sovereign debt rating by four notches to junk status, on negative outlook, with analysts highlighting the possibility of sub-investment grade ratings.

Moody’s downgraded Portugal from Baa1 to Ba2, on negative outlook, citing “growing risk that the country will need a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition”.

It also highlighted heightened concerns that Portugal will not be able to fully meet the deficit reduction and debt stabilisation targets set out in its loan agreement with the European Union and the International Monetary Fund.

Due to the linkage under Moody’s methodology between a sovereign’s ratings and that of its banks, and the relationship between banks’ ratings and those of their covered bonds, Portugal’s covered bonds are likely to face downgrades as a result of yesterday’s rating action, said analysts.

“Even taking into account Portugal currently having only a negative outlook compared to the review for downgrade of Greece in June 2010, the new Portuguese sovereign rating of Ba2 (compared to Ba1 of Greece in June 2010) will be a tough new reference for covered bonds,” said one analyst, describing the downgrade risk as “obvious”.

Moody’s ratings of Portuguese mortgage covered bonds range from Aa3 for Banco Santander Totta and Caixa Geral de Depósitos to Baa2 for Caixa Económica Montepio Geral.

The ratings of the obrigações hipotecárias from Portugal’s three other covered bond issuers are: Banco BPI: A1; Banco Comercial Português: A2; and Banco Espírito Santo: A2

All of the ratings were already on review for possible downgrade from Moody’s. Public sector covered bonds issued by Caixa Geral de Depositos and Banco BPI are rated A1 and A2, respectively, and also on review for possible downgrade.

At these rating levels, Portuguese covered bonds remain eligible for repo with the European Central Bank, but they may not be able to retain this status, covered bond analysts warned.

“In light of the ongoing rating migration, we caution that it will only be a matter of time before further downgrades, in some cases potentially to the sub-investment grade, might occur,” said Leef Dierks, head of covered bond and SSA strategy at Morgan Stanley.

Another covered bond analyst referred to a narrow gap of only one notch uplift between the rating of National Bank of Greece’s covered bonds (Baa3) and that of the Greek sovereign (Ba1, on review for downgrade) as a reason for seeing a “clear risk” of a junk rating for Portuguese covered bonds from Moody’s. However, given that the obrigações hipotecárias only need a two notch uplift from the sovereign rating to avoid being junked, the covered bonds could yet remain investment grade-rated, he added.

“In our view, a junk status for Portuguese covered bonds would be too harsh, also inside Moody’s own world,” he said.