* 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 (Reuters) - 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 mid-August.
“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 justified.”
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 head on.”
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.
For Reuters new Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets (Reporting by Abhinav Ramnarayan; Additional reporting by John Geddie; Editing by Alison Williams and Raissa Kasolowsky)