Once again this week, France was in the headlines as its 10-year borrowing rate exceeded that of all the ex-peripheral countries, for whom we’ll now have to find another name…

Trends in 10Y interest rates for France and “peripheral” countries

(Sources: Bloomberg, Octo AM)

In a June issue of our weekly newsletter, we pointed out that investing in French debt is unprofitable in view of the risks and outlook. However, contrary to what we have been reading here and there, we should point out that this divergence in French yields does not necessarily stem from investors’ particular distrust, nor from a clear demand for higher yields, for two reasons:

• Firstly, this divergence from other countries has taken place against a backdrop of falling sovereign yields since the summer, in parallel with the cut in the ECB’s key interest rate. As a result, France is borrowing rather more cheaply than in June 2024, and the following graph, while showing a clear increase in 2022 linked to the widespread return of inflation and higher yields, does not illustrate a clear trend of deteriorating investor confidence in French debt.

Trends in the French 10Y rate

(Sources: Bloomberg, Octo AM)

• Secondly, the interplay of supply and demand on the bond market depends not only on investors, but also on the stock of debt in circulation. As it happens, the stock of debt in countries such as Ireland, Portugal and Greece is very limited, due to their small economic size. Thus, despite a debt level still close to 120% in Portugal and 170% in Greece, their debt stock in absolute terms is around ten times smaller than the French debt. This implies a certain illiquidity in these bonds, especially as a significant proportion of their debt does not circulate on the markets. Thus, the ECB, various assistance programs and local banks – all portfolios that take bonds out of the classic game of supply and demand – will hold almost 70% of Portuguese debt in 2023, compared with 10% in 2010.

Holders of Portuguese public debt

• Thirdly, the ECB, in parallel with the rate cut, is in a relatively significant phase of reducing its balance sheet, as illustrated by the following graph. It should be noted that, when increasing or reducing its balance sheet, the ECB buys or sells European sovereign bonds on the market to inject or withdraw liquidity, and must do so according to allocation keys corresponding roughly to the economic importance of the country(https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.pr231221~173a7ba501.fr.html). For example, the ECB bought far more French or German sovereign debt than Portuguese or Spanish debt when it was in its expansionary phase, driving French and German rates into negative territory… Now that the period is one of reduction, it is indeed German and French bonds that the ECB must offload.
• Fourthly, and this is where the problem lies for France, there’s nothing wrong with the ECB not rolling over its investments in mature bonds if France had a balanced budget… But with a deficit of almost 6%, the Treasury is currently having to place a large number of new issues on the market, even though its biggest purchaser, the Central Bank, is in the process of reducing its balance sheet… So, although the various categories of investors are probably continuing to buy French bonds as much as before, both in absolute and relative terms, thus not necessarily showing any “mistrust” of France, it is indeed the excessive increase in the stock that is the problem…
• Finally, it’s not so much France that has lost the confidence of investors or its importance in portfolios – and let’s not forget that French corporate or sovereign debt represents around 30% of all European bond ETFs, rather, it is the other European countries that have made considerable efforts to reduce their deficits and clean up their economies, enabling them today to run budget surpluses, no longer borrow on the markets (thus making stocks scarcer than in France), and to enjoy relatively solid levels of growth, as illustrated by the three graphs below.

Portuguese, Spanish and Greek debt in billions: outstandings stabilized over the past 10 years

(Sources: Bloomberg, Octo AM)

Ireland’s debt-to-GDP ratio now among the best in the Eurozone

(Sources: Bloomberg, Octo AM)

Growth in Eurozone countries

(Sources: Bloomberg, Octo AM)

In conclusion, the fact that France’s borrowing rate is higher than that of other countries has as much to do with the ECB’s balance sheet reduction, which has particularly affected France; with the specific characteristics and a certain illiquidity of the debts of smaller European countries; with the improvement in the economies of ex-peripheral countries after a decade of effort; as with the deterioration – real though it is, and which we of course do not deny – in France’s public finances and economy. It is likely that this phenomenon will continue in the years to come for France and Italy alike, and that we will see further downgrades of the ratings of these two countries, and therefore perhaps of some of their companies, particularly in the financial sector, a relative widening of their borrowing rates compared with others, and in the longer term, a runaway crisis of confidence or a major economic and social crisis and a new rescue intervention by the ECB…

Two points to bear in mind, however:

• firstly, the ECB will not intervene without quid pro quo and will therefore wait, as it did for the peripheral countries, for a significant crisis before being able to negotiate major adjustments to the country’s political and budgetary management.
• Secondly, the time scales of governments and their political, geopolitical and budgetary balances are not at all the same as those of the financial markets or an investor, and we would warn against Cassandras predicting – and indeed already predicting some ten years ago – the imminent bankruptcy of France… Several decades and multiple political and monetary interventions, numerous economic and financial cycles will occur long before this could, one day, possibly happen.

However, the current yields of the French government and certain French companies linked to political risk, France’s credit rating or sovereign debt, such as banks and insurers, do not necessarily seem sufficient to us, and we prefer to limit our exposure to their bonds as much as possible.

Matthieu Bailly, Octo Asset Management