French bonds following the path trampled by Greece, Ireland, Portugal, Spain and Italy

We’ve already discussed how EFSF doesn’t work as a private sector solution to the Eurozone debt crisis here, and have explained how the idea of turning the EFSF into a monoline insurer is ludicrous here.  EFSF bonds continue to perform poorly – the inaugural €5bn 5 year EFSF bond issued in January came with a yield spread of about 40 basis points over 5 year German government bonds, and is today at 150 basis points.

However perhaps more worrying than the poor performance of EFSF bonds is the dire performance of French government bonds, particularly in the last couple of weeks.  French spread widening poses a major problem because the tail tends to wag the dog when it comes to credit ratings, as argued here.  In other words, widening spreads tend to cause credit rating downgrades, which tend to cause further spread widening. A French downgrade would be particularly problematic to the European leaders who still seem to believe that the EFSF is a tenable solution to the Eurozone debt crisis since the EFSF structure needs AAA rated guarantors. To quote FT Alphaville, the loss of France’s AAA rating would lead to the EFSF beast beginning to eat itself.

The chart below shows how long dated French government bonds have significantly underperformed long dated Germany, with spreads blowing out from 70 basis points in mid September to 124 basis points this morning.  More worrying still is that the French spread widening has not come about because Germany borrowing costs have plummeted – long dated Germany bond yields are at a similar level now versus where they were in mid September – but has instead come about because 30 year French government bond yields have jumped from a mid September low of 3.3% to above 4.0% today.

3 thoughts on “French bonds following the path trampled by Greece, Ireland, Portugal, Spain and Italy

  1. It’s hardly surprising that EFSF bonds don’t perform well, they are effectively a collection of all the credit ratings of Eurozone nations and some of the major ones, such as France are under threat. 

    There’s also political risk – what if the Eurozone breaks up with high levels of acrimony with some countries refusing to honour their obligations?

    To feel more comfortable about the EFSF I suspect investors would like much deeper fiscal integration, budget discipline and more fiscal power to some pan-Eurozone body – a hard sell politically.

    With France’s credit rating looking under threat and French bonds going the way of Italy bodes baldy for a solution to the Eurozone crisis.

    It leaves some sort of solution involving the IMF and the ECB doing QE. The former looks problematic and the latter has been totally ruled out – for the time being at least, but it would provide a short term mkt solution albeit with probable long-term side effects!      

  2. Michael, how much of this sudden vol is due to real money activity and how much to prop, hedge funds? There is too much speculative money in a very small boat, and with too many people shouting ‘fire’ at the top of their voice there is no balanced discussion of debt management
    Heinz

  3. It’s impossible to say exactly, although anecdotal evidence I’ve heard suggests that a reasonable amount of French widening has been driven by hedge funds.  Hedge funds have been attacking France via CDS for perhaps six months after it became more expensive to short Italy and Spain, but it appears that French cash bonds have been the recent focus of attention.  I gather that some of the investment  banks were very happy to take the other side of the trade as France widened out 60bps over Germany in the belief that being long of France was money good as France would never get into trouble.  They were still happy taking the other side of the trade as France widened out to 70 bps versus Germany, and then 80bps.  But once it went through 100bps, I think the market makers increasingly began to have doubts.  

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