For Big Bond Funds, It’s Too Soon to Buy France’s Debt Again

France has been in political limbo since elections in June and July left the lower house split into three fiercely opposed blocs that can’t agree on a path forward for the nation’s finances: a diminished center supporting the president, a leftist alliance and a strengthened National Rally, led by Le Pen, which is now the biggest party in the National Assembly.

Without having secured support from beyond that centrist set of parties, Barnier’s budget, which stipulated a deficit equivalent to 5% of economic output in 2025, was doomed to fail. While the focus will now turn to Macron’s effort to cobble together a new administration, the worry is that without a major political breakthrough in the coming weeks, the impasse will remain.

More Pain

“I struggle to come up with an optimistic scenario in the short term and medium term,” said Gareth Colesmith, head of global rates and macro research at Insight Investment. “There is an optimistic scenario in the long term, but unfortunately to get to it you have to have a lot of short term pain.”

The yield on 10-year French bonds rose to as much as as 90 basis points over German notes during the political turmoil in recent weeks, before closing at 77 basis points Friday. The spread was contained below 50 basis points before Macron’s decision in June.

Even after narrowing the gap in recent sessions, France’s borrowing costs are higher than those of the countries once at the heart of the region’s debt crisis. Ten-year yields are above those of lower-rated Spain and Portugal and roughly match Greece’s, upending the traditional hierarchy of European bond markets.

European Malaise

The situation is only worsened by the state of Europe’s economy. Germany, once the bloc’s powerhouse, has seen growth stagnate and is mired in its own political crisis. US tariffs would be another blow to its floundering export sector as the country goes the polls in February.

“This widespread instability is significantly impacting markets by creating uncertainty around growth and inflation outlooks, deficit trajectories, and future issuance needs,” said Orla Garvey, senior fixed income portfolio manager at Federated Hermes. “This trend is likely to continue into 2025.”

To be sure, it’s a long way from the turbulence of the European sovereign debt crisis. Spreads remain contained in both France and other issuers, compared with the yield blowouts seen then. The recent selloff in French bonds was sharp but has remained orderly, and French officials will be encouraged by the rally last week.

“Of course, there are still parallels with the sovereign crisis,” said Henry Allen, macro strategist at Deutsche Bank AG. “But if anything, what that crisis demonstrated is that there are strong incentives against market turmoil from all sides — few want to be held responsible for that.”

But it’s still a worry that Europe’s second-largest economy and biggest bond issuer is so susceptible to idiosyncratic political risk.

While French yields are about 30 basis points lower than those in Italy — a nation typically seen in sovereign bond markets as being among the riskiest in the region — some are starting to question whether that spread could be the next to flip.

“We feel that it is becoming appropriate to question the conventional wisdom that France is actually a better credit than Italy,” Mark Dowding, CIO at RBC BlueBay Asset Management, said. The past experience of other EU countries suggests that “change only occurs after a period of some pain and a prevailing sense of crisis.”

–With assistance from Margaryta Kirakosian.

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