French Bonds Face Sovereign Stress Test

Can France’s debt emulate that of the U.S. after its loss of its AAA rating?


Investors have found themselves compelled once more to rethink the concept of safe-haven assets, following the decision by one of the world’s leading debt rating agencies to knock France off its triple-A pedestal. Standard & Poor’s declared on Friday that the Fifth Republic no longer commanded the agency’s highest possible rating — cutting it by one notch to AA+. France’s fall came as S&P took an ax to ratings across the euro zone. It downgraded eight other countries, ranging from triple-A Austria to weaker regimes including Italy, Spain and Portugal, the latter falling two levels to junk bond status.

S&P justified the moves by warning that “the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the euro zone.”

News of the rate slashes — which leaked out drip-by-drip hours before S&P’s formal announcement following the closure of U.S. markets — sent the euro more than 1 percent lower to a 17-month trough against the dollar. Yields on Italian bonds — which have been flighty over the past few months, even during periods of relative market bonhomie — rose 12 basis points (bps) to 6.82 percent, before emergency buying by the European Central Bank pushed them back down. But yields on German Bunds — which retained their triple-A rating on Friday, along with the sovereign debt of Finland, the Netherlands and Luxembourg — were 6 bps down on the day at 1.78 percent, diving deeper into negative real-term territory after allowing for inflation.

Investors will closely await the European market’s reaction in the coming days, as traders have their first opportunity to react to Friday night’s official confirmation of the leaked S&P downgrades. Despite France’s position at the center of Friday’s storm, yields on 10-year French debt were almost unchanged as European markets closed, at 3.07 percent.

In recent months, some analysts had suggested the loss of the triple-A imprimatur would not necessarily send French yields soaring, after speculation started to swirl about a downgrading by one of the major agencies. They pointed to the example of the U.S., where yields on Treasuries have fallen to record lows for the modern era since the August downgrade by S&P from triple-A. By ratcheting up fears about the global economy, the downgrade sent investors racing into classic safe-havens such as Treasuries. It is possible that France could benefit in the same way from a flight out of riskier assets this week in response to the mass euro zone rating reductions — all the more so, as its fiscal deficit is lower as a share of gross domestic product than that of the U.S.

But other analysts think French bond prices could be severely damaged by the downgrade, since they are skeptical that French debt basks in the same safe-haven aura as U.S. Treasuries. When the French government tries to attract risk-averse investors, one fly in the ointment is Germany, whose bond market is arguably safer and unarguably larger. Many institutional investors that want low-risk euro-denominated assets feel they do not need to look further than German Bunds — perhaps adding a smattering of bonds from smaller triple-A countries such as the Netherlands.

France also lacks a key advantage held by Treasuries: the U.S. Federal Reserve is able to shore up the bond market by acting as the buyer of last resort, purchasing unlimited quantities of U.S. debt to forestall any impending crisis. By contrast, Mario Draghi, president of the European Central Bank, has emphasised that the ECB’s buying of euro zone government bonds in response to the sovereign debt crisis is both “limited” and “temporary.”

Even if French bonds hold steady this week, financial markets may well mete out punishment to other countries such as Italy for their downgrades. Even after its rate reduction, France’s debt is still a solid AA+, the second-highest possible rating. Italy’s has fallen to BBB+, only a few notches above junk bonds. This latest blow to the country’s attempt to finance its huge public debt came hot on the heels of Friday morning’s tepid auction of three-year bonds, which left analysts wondering whether demand for Italian sovereigns will be strong enough in the coming months. The sale attracted a low bid-to-cover ratio (demand over supply) of only 1.22.

Since the financial crisis began in earnest in 2008 institutional investors have regularly been forced to question their assumptions about which assets are safe-havens — with French bonds the latest in a long line. Some pension funds have fled from several euro zone sovereign debt markets once regarded as risk-free. Gold has periodically suffered sharp declines since reaching a record high in August, on fears that the price has hit bubble territory. Some defensive blue-chip stocks such as Tesco, Britain’s biggest retailer, have suffered sharp price falls as muted consumer spending has hit earnings.

The euro was at $1.27 at the close of U.S. trading on Friday, down from an October peak of $1.42.