After claims of accounting irregularities in the parent company of its largest bank, we see some signs of contagion in Portuguese assets.

• Both Portuguese sovereign bonds and those of its second largest bank have seen their CDS spreads surge over the last month
• Portugal Telecom, which has been the target of sustained short interest, has seen its CDS spread surge as it announced a large exposure to related debt
• Despite the recent spate of bad news, ETP investors look set to stay the course as Portuguese ETPs have managed to hold on to their inflows

Portugal’s road to recovery looks to have hit a roadblock this week as its largest bank, Banco Espirito Santo (BES), was dragged into its parent company’s recent debt struggles. These developments have seen BES shares tumble by over 40% over the last month as investors took stock of the fact that its largest shareholder (which also owes it over €800m according to a recent filing) delayed coupon payments after facing accounting irregularities

The unfolding situation has seen BES’s CDS spread surge to 394bps as of the 9th of July, which is nearly two and a half times the spread seen a month ago. The latest jump now sees BES’s spread trade at its widest level in over nine months.

While many investors are pointing fingers as to who should shoulder the blame for the latest accounting scandal, it seems that an early clue to the financial struggle faced by BES’s parent company was to be found in its recent rights issue prospectus, which highlighted the “serious financial condition” of Espirito Santo International (ESI).

Interestingly while BES’s CDS spread looks to have continued to tighten despite the apparent trouble in its parent company, CDS trading patterns did highlight some bearish sentiment as highlighted by our partner Leading Risk’s CDS trading signal back at the end of May, when traders bought a disproportionate amount of short term protection compared to historical trends.

Collateral damage

BES’s recent struggles have also caused their fair share of waves within the top Portuguese shares, several of whom have cross holdings in various entities tied the scandal.

Top of the companies feeling the direct impact of ESI’s struggle is Portugal Telecom which recently revealed it held €897m of commercial paper in Rioforte, a fully owned subsidiary of ESI. This disclosure saw Portugal Telecom shares slump by a third and have angered Brazilian telecom firm Oi with which it is trying to merge. On top of being exposed to ESI debt, Portugal Telecom also holds 1.6% of BES’s shares whose value has tumbled as mentioned previously.

Alongside seeing its shares tumble, Portugal Telecom has also seen both its debt and equity become the target of increased bearish sentiment after seeing an increase in demand to borrow and a widening of its CDS spread.

Another company to see an uptick in short interest is Banco Comercial Portugues which has seen demand to borrow surge by a quarter in the week after it closed its latest rights issue. Its CDS spread has also widended in the wake of its peer’s strugles.

ETP investors hold the course

ETP investors have so far stayed the course with their Portuguese holdings despite fact the PSI 20 index against which all three Portuguese ETPs are benchmarked has fallen by 12% in the last four weeks. These three funds have seen their AUM jump by 50% since the start of the year after seeing just over $50m of inflows. So far in July, these ETPs have seen $2.9m of inflows.