LONDON Investors are betting that after cap-in-hand Greece comes Portugal, selling off its stocks and bonds in the belief that the euro zone laggard cannot avoid a default without a second bailout.
While borrowing costs have fallen for debt-ridden Spain and Italy as well as bailed-out Ireland on the back of a huge infusion of low-cost loans from the European Central Bank, Portugal's have shot up, setting it on a path towards bankruptcy.
The rot really set in two weeks ago after Standard & Poor's downgraded 15 euro zone countries, putting Portugal in the "junk" category, along with Greece. That shuts it out from tapping capital markets in the foreseeable future and makes its task of meeting future debt repayments even tougher.
Since then, the rise in both government bond yields and the cost of insuring debt against default has been relentless.
This is the opposite of what has happened in Ireland, which was bailed out in November 2010 just six months before Portugal received a 78 billion euro bailout from international lenders.
"If we look at where bond yields are for Portugal it makes it impossible for Portugal to access debt markets in 2013," said Nikolaos Panigirtzoglou, a rate strategist at JPMorgan.
"It's a country that still relies on the official sector in terms of financing its current account deficit and repayments and this makes it certain that we're going to get a second bailout for Portugal later this year."
Portuguese debt and stocks have fared far worse than other highly-indebted euro zone given worries it could follow Greece and need to restructure its debt.
The absolute level of 10-year yields, which reflects how much payment investors are demanding to hold the country's debt, has risen three percentage points to 15 percent since S&P moved on January 13. This is almost double the equivalent Irish yields, which have fallen to their lowest in over a year over the same period.
Unlike Portugal and Greece, Ireland has moved to surplus on its current account over the past year in its fight to rebuild investor confidence.
"Ireland ... is a different case in the sense that its private sector at least is doing OK and is growing and generating trade surpluses," said Richard Batty, investment director at Standard Life Investments.
Ireland still faces hurdles, particularly given a weakened growth outlook on top of a debt ratio officially forecast to peak at 119 percent of economic output next year. But it is campaigning on a number of fronts to improve its chances of funding itself fully for 2014.
Portugal, Ireland, Italy government bond spread
Portugal and Ireland CDS
Portugal economic overview
What is worrying investors about Portugal is that two- and five- year Portuguese debt now yield more than longer-term bonds at 16.7 and 20 percent respectively. This mirrors the trend in Greece before it sought a second bailout package in 2011.
In a normally functioning market, short-term government bonds yield less than long maturities as investors want higher compensation for the risk of holding the asset for longer
Simon Derrick who heads foreign exchange strategy at Bank of New York Mellon says his bank's custodial data shows long-term investors have stepped up sales of Portuguese debt in the past month. This is likely to have gathered momentum after the country was downgraded to junk status.
Indeed, the credit market has highlighted investors' growing worries about Portugal's ability to repay debt in the coming years and the growing divergence from Ireland. The cost of insuring one- or two-year Portuguese debt using credit default swaps (CDS) is stubbornly above the equivalent premium for five-year debt.
Typically, five-year CDS trade above shorter-dated ones, as is currently the case in Ireland.
Banks issuing insurance, moreover, are demanding that a percentage of the total amount to be insured in Portugal must be paid when the contract is entered into, typically a signal that a credit is distressed.
"What's happening now with Portugal is very worrying and the market is asking whether Portugal is really just like Greece," said Standard Life Investments' Batty. "Portugal has never been able to grow itself sufficiently and in the current environment you have to ask 'how can they compete?"
Standard Life Investments, which has some $233 billion in assets under management does not hold any government debt of bailed-out European sovereigns Greece, Portugal or Ireland.
Investors are particularly concerned about whether Greece can be ringfenced and not trigger a domino effect that snares Portugal and larger euro zone economies Spain and Italy.
Part of their concerns stem from the fact that Portugal had to seek a bailout from international lenders not too long after Greece was given a record rescue package.
Highlighting a growing sense of inevitability that Portugal is heading for serious trouble, credit market prices are implying a near-70 percent default probability on a five year time horizon.
That chimes with a Reuters poll of 50 bank economists which showed a median 70 percent chance that the country will need more help with its financing at some point.
Only 10 gave a less than 50 percent probability of a second bailout.
Antonio Saraiva, the head of Portugal's industry confederation, said the country needs an additional 30 billion euros in extra European Union and International Monetary Fund aid.
The picture is so grim and with Portugal not be able to return to market funding until 2013 at the earliest, some analysts believe it will require additional bail-out money from international lenders sooner rather than later.
It should get it, if needed, because the country has so far complied with the fiscal austerity measures that are tied to such aid.
But additional funding isn't likely to solve the problems and some believe that, like Greece, it will all end up with private creditor like banks taking a big loss, or "haircut" to use the jargon.
"We expect that eventually Portugal will face a PSI (private sector involvement) debt restructuring with a haircut of around 35 percent," Michael Saunders, an economist at Citi said, adding he expected it in the end of 2012 or early 2013.
Indeed, the face value of 10-year Portuguese government bonds stands around 46 cents in the euro, implying holders fear they will not get all their money back.
(Additional reporting by Mike Dolan and Simon Jessop, Graphics by Scott Barber, Editing by Jeremy Gaunt)
(This story corrects paragraph five to show the Ireland bailout was before Portugal)