Italian, Spanish and Portuguese bond yields fell on Friday after Greece sent a package of reform proposals to its euro zone creditors in a last-ditch attempt to get new funds and avoid bankruptcy. The Greek government has asked for 53.5 billion euros to help cover its debts until 2018, a review of primary surplus targets and a "reprofiling" of the country's long-term debt.
In turn, Athens bowed to demands to phase out tax breaks for its islands and to raise taxes on shipping companies. The government will seek a parliamentary vote on Friday to endorse immediate actions. The market sees the reform proposals as a step towards reaching a deal at the weekend and avert the risk of Greece's running out of money and crashing out of the euro zone, but some investors are still urging caution.
"The price action would suggest that there is a bit more optimism for a deal but I think many investors are still keeping their powder dry," said Sandra Holdsworth, an investment manager at Kames Capital, who is invested in Italian and Spanish bonds. "A deal doesn't solve Greece's problems, I think we've got to look at it carefully and how sustainable it is and what that means for other riskier assets." Italian and Spanish 10-year yields fell 4 basis points to 2.13 percent, while Portuguese yields fell 7 bps to 2.87 percent.
The three indebted euro zone countries are the most vulnerable to the Greek crisis, but so far contagion has been limited - the European Central Bank's trillion-euro bond-buying stimulus programme has capped borrowing costs. The possibility that the ECB could even accelerate bond purchases if "Grexit" had a severe market impact has given peripheral bondholders some comfort in the past week, but that will be off the table if a deal is reached.
"Although experiences of the past caution against too much optimism as there have been many unexpected twists and turns, chances for a deal and another bailout for Greece have increased again," said Carsten Brzeski, chief economist at ING. France and Italy welcomed Greece's reform proposals, but Germany remained wary. French President Francois Hollande said they were "serious and credible". Finance ministers of the 19-nation euro area will meet on Saturday to decide whether to recommend opening talks on a new bailout. A senior EU official said Greece's debt burden and whether it needs some debt relief will also be discussed.
"A plan containing a debt restructuring, something along the lines of a maturity extension and possibly a variable coupon on the debt, could be tied to reforms so I think this is ... the middle ground," said Peter Chatwell, a strategist at Mizuho. "Syriza would be able to sell this domestically as a 'sustainable reform', while Europe would still have a debt-noose around Greece's neck ... For all politicians involved it would probably look like a win-win."
Euro zone leaders will take a final decision at a summit on Sunday. Ten-year German Bund yields, which set the standard for euro zone borrowing costs, rose 8 bps to 0.81 percent, as appetite for low-yielding, top-rated assets vanished. "Markets now seem optimistic that a deal will be cut, although important obstacles still need to be cleared," said Elia Lattuga, fixed income strategist at UniCredit.
Greek bond markets showcased the optimism in their usual erratic fashion. Ten-year yields were quoted around 5 percentage points lower at 13.71 percent, while two-year yields plunged 25 points to 33.62 percent. Data from Markit showed the cost to insure Greek debt against default via five-year credit default swaps dropped to 58.75 percent upfront from 60.58 percent on Thursday.
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