Spain Ratings Cut Could Prompt $80 Billion Bond Selloff: Morgan Stanley

The rise in Spain’s bond yields to above 7 percent raises the issue of potential further ratings downgrades for the country leading to it dropping out of major European bond indices and foreign investors selling off the country's bonds en masse, according to Morgan Stanley.

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Spain’s most recent bond auction saw yields on 10-year bonds climb above the perceived “point of no return” of 7.625 percent, prompting fears that the country, which is already on review for downgrade with a negative outlook, will have its rating downgraded to below investment grade by major ratings agencies Moody’s, S&P and Fitch.

Such a move would see the country progressively excluded from the major indices, according to Morgan Stanley, and could prompt a major selloff of by index-benchmarked funds of up to 66 billion euros ($79.9 billion) worth of Spanish government bonds — 13 percent of the market — according to a Morgan Stanley research note.

However, Morgan Stanley notes that if only Moody's were to downgrade Spain, which represents 10 percent of overall European government bond markets, to below investment grade, the country would only fall out of the lesser-used Barclays European Government Bond Index and only a fraction of the estimated sell-off would occur.

Although the research note says the relegation of Spain to a sub-investment standard is unlikely, the country has seen a 3 percent loss on its national IBEX stock index over the last three days as investors fear that a full 400 billion euro sovereign bailout will be necessary.

Regional governments have declared the extent of their individual debt and even regions traditionally perceived to be healthy economically such as Catalonia are now needing funds totaling up to 13 billion euros.

The Spanish government had hoped that an initial 100 billion euro bailout of its banks would suffice to stop investors demanding such high interest rates on its government debt, but Tuesday's auction showed yields for short-term debt once again at euro-era record highs.