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Greece - Portugal 2 Year Yield Spread

S&P has cut Greek Govt. Debt to junk status and Portugal's ratings from A+ to A- (just 4 notch above junk status). We all know that, but the question is: Is there an opportunity for profits out of a potential misalignment?

Take a look at the chart below, focusing on the Greek Yield Curve and that of portugal directly below it. A couple of observations:

1) Inverted yield curve for Greece, with yields on shorter maturities in excess of 14%

2) Portugal yield curve is generally flat, indicating mixed sentiments within the market. This is typically seen as a transition form a normal yield curve to an inverted curve

3) Note that the spread on the 2 year is in excess of 9%. This, in my opinion, offers fixed income investors a sweet spot for trading on a tightening of the spreads between Greek 2Yrs and Portugal 2Yrs


 

Going forward, one of two things might happen:

A) EU finance ministers agree to a 600Bn bailout fund. Calm markets, yields decline. Greek Govt. securities being at the heart of the "crisis", are significantly more sensitive and the Greece-Portugal 2 year yield spreads tighten. I think that such an outcome is unlikely, although I would not rule out the possibility of such a massive bail out package.

Let's not forget that the EU is primarily a political construct and it appears thus far that EU political leaders (probably except Meckel) are not in favour of letting any of its member countries go into default. Further, 600Bn is just slightly north of the American US$ 700Bn TARP

B) The alternate scenario, which i think is a more realistic prediction of things to come, is that contagion fears continue to spook investors. Greece draws down on the safety net that has been agreed in principle by the EU last week and yields remain near current levels. Investors begin to shun sovereign debt of other peripheral EU countries like portugal, sending yields higher. Again, we see a tightening of the Greece-Portugal yield spreads as their perceived credit quality converges.

Whatever the outcome, it might be a good idea to be long Greek debt while simultaneously going short Portugese government bonds.


Disclosure: No positions