France is facing one of its deepest fiscal and political crises in decades – and the consequences are reverberating through its sovereign bond market.
Mass protests swept across the country last weekend, as public anger over the government’s austerity plans spilled onto the streets.
The unrest adds to growing pressure to bring public finances under control, as France attempts to reduce its deficit from 5.4% of GDP this year to 5% in 2027 through a €54bn fiscal adjustment package. Yet public debt is projected to breach 120% of GDP, while annual interest payments are expected to jump from €79.2bn to approximately €92.1bn.
Before the protests, bond markets were already rattled by months of fiscal and political uncertainty. France’s 10-year OAT yield rose a further eight basis points to 4.86% at the start of the week, widening the gap with German Bunds at 3.41%, while the OAT two-year yield rose to 3.64% and the 30-year climbed to 5.46%.
It is not a reassuring picture for fixed income managers, with many erring on the side of caution in recent months, even as some see pockets of value.
Patrick Barbe, European fixed income head at Neuberger, said he has been “significantly short” on French OATS over the past few months but the recent sell-off led him back to neutral.
“Considering France’s fundamentals and its rating, and its annual supply achievement (92% of the annual OAT programme is done), we believe that the magnitude and speed of the widening of the OAT spread are somewhat excessive,” he said.
Meanwhile, Christophe Boucher, chief investment officer at ABN AMRO Investment Solutions, noted the firm is currently neutral-to-slightly-underweight French government bonds, arguing the market is pricing a level of long-term sovereign risk that appears “excessive” relative to France’s actual default risk over the medium-term.
That said, Boucher remains cautious as he expects spreads to remain elevated or widen further if political uncertainty increases, “particularly in the event of stronger momentum for more radical parties in future opinion polls”.
Dan Bright, portfolio manager at Aviva Investors, has also been cautious for much of the year, staying neutral or underweight.
“However, with the underperformance in September, we see French spreads as now offering reasonable compensation for most political outcomes and have entered a modest overweight,” Bright said.
While the issues unsettling the bond market are France-specific, Europe-focused investors are not viewing the situation in isolation, with managers citing their concern that volatility could spread into other European markets.
Al Cattermole, fixed income manager at Mirabaud Asset Management, said: “France is too large a sovereign market for prolonged stress to remain completely isolated, so we would expect bouts of volatility across European government bonds if French spreads continue to widen.”
He argued that there is already some contagion in other European sovereigns, such as Italy.
Will the ECB get involved?
The widening spread between French and German government bonds puts the European Central Bank (ECB) in an awkward position – tasked with taming inflation on one hand while facing growing pressure to prevent sovereign stress from spiralling on the other.
Katharine Neiss, chief European economist at PGIM Credit, said: “If stress were to spread to other eurozone sovereign markets, the ECB could potentially deploy its Transmission Protection Instrument for non-French euro area sovereigns to help restore market functioning.”
The emerging bond-buying tool, created in 2022, allows the central bank to buy the government bonds of a specific eurozone country to prevent its borrowing costs rising too high.
However, the ECB is unlikely to ride to France’s rescue until the government shows a willingness to address its budget deficit, according to David Roberts, head of fixed income at Nedgroup Investments.
He referred back to Italy in 2011, when Italian spreads over German Bunds hit 500 basis points before the ECB acted.
“France likely needs to get to between 225 to 275 basis points over Germany before the ECB would feel compelled to step in,” Roberts said.
Instead, managers agreed that the ECB’s primary focus will remain on bringing inflation back under control.
Maxime Darmet, senior economist for France, UK and US at Allianz Trade, said: “Concerns about rising sovereign borrowing costs, such as in France, are unlikely to prevent the ECB from delivering the rate hikes it considers necessary – indeed, easing off too early could undermine its credibility and push up longer-term bond yields through a higher inflation risk premium.”
Following its October pause, Darmet expects the ECB to deliver two further rate hikes by the first quarter of 2027.
Opportunities across the eurozone and beyond
Managers are nonetheless finding pockets of value within European fixed income. Boucher said there is value in the investment-grade bonds issued by high-quality issuers.
“This segment benefits from generally solid corporate balance sheets and lower sensitivity to political developments than sovereign debt markets,” he said.
Meanwhile, Rikkert Scholten, strategist at Robeco, noted “consistent improvements” in the fiscal outlook for countries such as Portugal and Greece, while Lisa Wang, head of EMEA investment strategy at Franklin Templeton Investment Solutions, argued German government bonds “offer the clearest combination of safe-haven demand and potential gains if fewer rate hikes are needed than feared”.
Looking at other developed markets, several managers flagged Australian sovereign bonds.
Lauren van Biljon, senior portfolio manager in the global fixed income team at Allspring Global Investments, pointed out that the Australian central bank has been a “frontrunner” when it comes to rate hikes.
“This means they are closer to the end of their hiking cycle, while fundamentals are among the more robust on the global stage and valuations are good – so it’s somewhere where the intermediate part of the yield curve looks attractive,” she said.
The appeal of Australian government bonds was separately highlighted earlier this month by Fidelity fund manager Mike Riddell, who flagged the market as his highest conviction trade on the basis that the country’s collapsing housing market will force the Reserve Bank of Australia to cut rates.
Along a similar vein, Wang said Canada is a “clear alternative”, with underlying inflation closer to the target, which gives the Bank of Canada more scope to hold rates while other central banks face pressure to tighten.