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By Archana Narayanan

DUBAI, Feb 18 (Reuters) - Bahrain's government cancelled a $750 million bond sale on Thursday after Standard & Poor's downgraded its rating of the kingdom's debt to junk status, underlining the financial pressures on Gulf states in an era of cheap oil prices.

Late on Tuesday, Bahrain launched a $750 million, two-part bond sale at the tighter end of its pricing guidance, expanding the borrowing size by $250 million from its original target after it attracted over $1.35 billion of orders.

But on Wednesday, S&P cut Bahrain by two notches to 'BB/B' with a stable outlook, pushing the rating below investment grade and making Bahrain the first of the wealthy Gulf oil exporters to suffer that fate in the current downturn.

"We expect the impact of lower oil prices will further strain Bahrain's already weak fiscal and debt metrics to the extent that we now view these credit measures as consistent with a 'BB' rating," the rating agency said.

That angered investors who had ordered the bonds just before the downgrade. Traditionally, rating agencies inform an issuer of any impending rating changes before events such as a bond issue, investors said.

"The news has yet to sink in," said one Gulf-based investor who bought into the bond. "We were prepared for a one-notch downgrade but two notches lower is a shock."

After consulting lead managers of the issue, Bahrain's central bank said on Thursday afternoon that it had decided "to not proceed" with the sale. It is very rare for sovereign governments to cancel debt sales once they have begun.

Bahrain's big state budget deficit, created by low oil prices, means it will have to try again to borrow from international markets, but it is likely to have to do so at higher prices.

"Any future transaction will be subject to market conditions," the central bank said without elaborating.

While the other two big rating agencies, Moody's and Fitch, rate Bahrain one notch above junk status, they have negative outlooks on the kingdom. Many investors are barred from buying junk bonds, so Wednesday's downgrade will have shrunk Bahrain's pool of potential investors.

"While the bonds have cheapened up over the last few months, Bahrain is an off-benchmark investment for us...and we have seen greater investment opportunities elsewhere in emerging markets," said Anthony Simond, an investment manager who helps oversee about $10 billion of emerging-market debt at London-based Aberdeen Asset Management.

"The investment case for Bahrain is often tied to perceived sovereign support from Saudi Arabia, which is also under pressure."

Bahrain's rating cut came alongside S&P downgrades of Saudi Arabia, Brazil, Kazakhstan and Oman on Wednesday. S&P's action may presage a round of cuts by other issuers this year.

"Ratings downgrades are likely to reduce bond prices, however the magnitude of actual price decline may be contained in view of the recent material widening of credit spreads and much anticipated nature of these developments," said Anita Yadav, head of fixed income research at Emirates NBD, Dubai's biggest bank.

Earlier this month, volatility in the Gulf's debt market prompted Oman Telecommunications Co to scrap plans for a $130 million, five-year dual-currency sukuk issue. It received enough commitments to sell the bond but decided the rates it would have to pay were too high.

(Editing by Andrew Torchia) ((andrew.torchia@thomsonreuters.com; +9715 6681 7277; Reuters Messaging: andrew.torchia.thomsonreuters.com@reuters.net))