The rating agency said up to now the "overwhelming part" of Sri Lanka's foreign debt was concessional and was an "explicit supporting factor" for the speculative grade rating.
S & P said the support was there despite a depreciating currency that increased the burden of servicing commercial loans and also increased the risk of rolling over commercial debt.
"Hence, further recourse to commercial external funding, which would excessively raise the foreign exchange denominated interest burden and debt amortization commitments relative to the country's foreign exchange generation capacity, could potentially diminish what has so far been a supporting factor behind the sovereign ratings," Standard and Poor's said.
Government officials have said earlier that they were looking for 500 million dollars of 10-year funds through the maiden sovereign bond issuance, which is managed by JPMorgan Chase, HSBC and Barclays Capital.
Inflating
S&P said last year the government had managed to reduce national debt from 93.9 percent of gross domestic product (GDP) to 93 percent by printing money, driving inflation up and keeping interest rates below inflation.
"The sovereign's positive debt dynamics largely relied on an accommodative monetary policy stance, whereby negative real interest rates allowed the financing of large fiscal deficits without a corresponding rise in public debt as a share of GDP," S& P said.
Though total debt grew by 17 percent, economic growth with inflation was higher at 18.4 percent, allowing the ratio to fall, the rating agency said.
"This in turn underscores the fact that the positive debt trajectory is vulnerable to either a slowdown in economic activity--an increasing possibility with projected easing of global growth--or if inflation comes down to near the level of trading partners or similarly rated sovereigns," S&P's credit analyst Agost Benard warned.
"These factors are balanced against the economy's demonstrated resilience and favorable medium-term growth prospects, as well as the benign terms of external debt, which impose minimal stress on external liquidity".
The rating agency said tax hikes and fiscal administration had increased the tax take of 15.3 percent last year with better compliance, while the elimination of an oil subsidy and increases in electricity tariffs are set to reduce negative effects on the economy.
"These measures suggest the continuation of modest deficit reduction, which, combined with high nominal GDP growth, should yield further improvements in the sovereign's still high debt ratios," said Benard.
"The ratings on Sri Lanka also reflect the high level of government indebtedness, and ongoing primary fiscal deficits, together with risks posed by the unresolved separatist conflict."
Though S&P says energy is being market priced, a senior Sri Lankan senior minister has said that electricity tariffs would not be increased this year and a monthly fuel adjustment formula has been suspended for two months in line with his pronouncements.
The agency said so far, the impact of a collapsing ceasefire with the Tamil Tigers had been limited.
"Undoubtedly, Sri Lanka's economy has demonstrated considerable resilience to the conflict that has been ongoing for the past two and a half decades," Benard observed.
"However, depending on how the conflict unfolds, it could yet become the source of downward pressure on the ratings.
"Such pressure may occur if the separatist struggle deteriorates to an extent that it depresses investor sentiment, impairs revenue generation and foreign exchange earning capacity, and compels a rise in defense expenditure."
Standard & Poor's expected that, in line with government plans, an all party peace proposal will be tabled before the end of the calendar year.
"While this may not entirely satisfy LTTE demands to end the conflict, it will ease tensions and help buoy economic growth," S & P said.
"The ratings could also come under downward pressure, or the outlook could return to negative, if there are signs of fiscal slippage, where, either through expenditure pressures or lower revenues, deficit reduction grinds to a halt."
The agency said it had also given a recovery rating of '4' for the sovereign bond indicating average recovery in the range of 30 percent to 50 percent to Sri Lanka' senior unsecured debt.
S&P said the assigned issue rating for the global bond is a product of Sri Lanka's sovereign rating and the newly assigned sovereign recovery rating.