European credit markets flashed a dangerous warning signal overnight, as investors took fright at Portugal’s latest downgrade to junk status and the warning that a plan to include private sector creditors in Greece’s next bailout could amount to a default.

Analysts warned that the eurozone sovereign debt crisis appeared to be on the cusp of a new and riskier phase, with eurozone bond markets being buffeted by heavy selling, and with the share prices of banks with heavy exposure to debt-laden “peripheral” countries under pressure.

Two-year Portuguese bonds suffered the heaviest selling, with yields climbing 3.8 percentage points to 16.74%. Bond yields have an inverse relationship with prices. But nervousness spread to the other “peripherals”, with Irish two-year bonds climbing almost 300 basis points to 14.5%.

In view of the dismal mood in eurozone bond markets, the French toll-road operator Autoroutes du Sud decided to pull its planned sale of €500 million ($US716 million) seven-year bonds.

Growing nervousness about heavy levels of Italian indebtedness pushed yields on 10-year Italian bonds above 5% for the first time since November 2008. Analysts are increasingly worried that Italy has almost €900 billion of debt maturing over the next five years, and that rising borrowing costs will put an increasing strain on the country’s finances.

The anxious mood in the markets intensified as it became clear that senior German officials now want to re-examine the possibility of forcing private sector creditors — such as banks, insurance companies and pension funds — to bear a larger share of the cost of Greece’s second bailout, estimated to cost as much as €120 billion.

The French banks had devised a scheme aimed at encouraging private sector creditors to roll over some of their maturing loans into long-dated Greek bonds. But this plan hit a snag this week after ratings agency Standard & Poor’s said it could treat the plan as a default. It was also clear that the private sector’s contribution to the bailout would be less than the €30 billion target that eurozone governments had wanted.

Overnight, German Finance Minister Wolfgang Schäuble said there were “many reasons for an alternative” to the French banks’ plan. His deputy, Jörg Asmussen, told Reuters Insider TV that because the French proposal would be considered a default, “we can also put other options, like a bond exchange, on the table”.

Germany had previously come up with a scheme that would induce investors with bonds maturing between 2012 and 2014 to swap them into new bonds that would mature seven years later. However, the European Central Bank forcefully rejected the German plan, arguing that the ratings agency would call a default. The ECB threatened that if Greece defaulted, it would no longer be able to accept Greek bonds as security for loans. Given that Greek banks are heavily dependent on the ECB for funding, this could trigger a collapse of the Greek banking system.

Meanwhile, one area where European officials were able to find common ground was in their condemnation of the ratings agencies. In particular, Moody’s came under fire for downgrading Portuguese bonds to ‘junk’ status earlier this week.

José Manuel Barroso, president of the European Commission, said the Moody’s report contained mistakes and exaggerations. “I deeply regret the decision … and I regret it both in terms of its timing and its magnitude,” he said. Meanwhile, Schäuble hinted that the big three ratings agencies — Standard & Poor’s, Moody’s and Fitch — could find themselves under increasing pressure. “We can’t understand the basis of this announcement,” he said. “We have to break the oligopoly of the ratings agencies.”

According to Der Spiegel, the Italian securities market regulator, Consob, summoned a representative of Standard & Poor’s earlier this week to explain why the ratings agency had warned of a possible downgrade of Italy’s rating. In particular, S&P was asked to explain why it had made a negative assessment of the country’s latest austerity program before the details of the package had been released.

The European Union has already tightened its rules on credit ratings agencies, and the newly created European Securities and Markets Authority has been regulating their activities since the beginning of this year. Der Spiegel reports that ESMA has “even threatened to withdraw the US agencies’ European licences if they do not abide by the new European rules”.

*This first appeared on Business Spectator.