March 16, 2020 / 6:29 PM / 13 days ago

French bonds fall out of favor as coronavirus puts focus back on debt

LONDON (Reuters) - Just a few weeks ago France’s big bond market was benefiting from heightened global volatility. Now, sentiment has soured as investors bet that dealing with the effects of coronavirus will blow a bigger-than-expected hole in the country’s finances.

The yield on France’s 10-year bond soared on Monday to a nine-month high around 0.20% FR10YT=RR, while the cost of insuring against a default has doubled over the past week in the five-year credit default swaps market, climbing to the highest levels in just over a year.

As recently as Friday, France paid investors negative yields on 10-year debt, alongside peers such as the Netherlands and Germany, which are widely seen as some of the strongest credits in the world. France is also seen as one of the so-called “semi-core” euro zone economies, in contrast to weaker southern states such as Italy that are sometimes grouped together as “the periphery”.

“France is considered a safe asset under other circumstances, but this is now a story about public finances - and that’s a weak point for France,” said an official at a bank which acts as a primary dealer for French government debt.

“Unlike Germany, France has been running a deficit for a while now, its debt-to-GDP ratio is much higher, and there will be even more pressure on public finances as this coronavirus response begins.”

The change in investors’ perception of France is sudden but perhaps unsurprising.

Like its neighbors, France is battling to protect its economy from the virus outbreak, closing retailers, cafes and iconic destinations such as the Eiffel tower. It has also pledged to spend tens of billions of euros to help companies get through the fallout.

Les Echos newspaper said Paris was preparing a support package of 30-40 billion euros ($33-44 billion) though the government has so far dismissed a potentially costly bailout for struggling carrier Air France KLM (AIRF.PA).

Other euro zone states face these risks too, with cash-strapped companies, ranging from Germany’s Tui to Amsterdam ‘s Schipol airport begging for aid. The difference is France’s weaker starting position.

France, the euro zone’s second-biggest economy, has a debt- to-GDP ratio close to 100%, in line with Spain. Germany’s figure is around 60%, and unlike France, whose budget deficit may widen above 3% of gross domestic output this year, it has run a budget surplus for years.

In short, France has less wiggle room to help its stricken firms or just for growth-boosting spending.

“When we take a long-term view, we do penalise countries if they have a very high debt-to-GDP ratio versus their peers,” said Salman Ahmed, investment strategist at asset manager Lombard Odier.

Worries about deteriorating French debt dynamics explain why the gap between French and German 10-year bond yields has doubled in the space of two weeks to around 60 bps DE10FR10=RR. Essentially that's the premium investors demand to hold French debt over Germany.Graphic - France's 10-year bond yield, gap over Bund yields: here

Five-year credit default swaps, trading at 38 bps on Monday FRGV5YUSAC=MG, have shot up over 20 bps over two weeks.

French development agencies could also be vulnerable. Caisse d’Amortissement de la Dette Social (Cades), an agency created in 2004 to help reform French social protection, has seen its bonds sell off in the last three sessions.

The yield on a December 2025 bond from Cades FR0011192392= rose six basis points on Monday and was nearly back in positive yield territory, after having traded at -0.495% just last Thursday.

In times of stress, such as that created in markets and economies by the coronavirus pandemic, investors tend to focus on each country’s vulnerabilities.

Investors note the French spread widening comes as other vulnerable euro zone markets face pressure from European Central Bank chief Christine Lagarde’s off-the-cuff remark that it was not the central bank’s job to “close spreads”.

She has since backtracked, but the market moves will have underscored the importance of a clear and forceful message from policymakers on supporting weaker euro zone states, said Valentijn van Nieuwenhuijzen, chief investment officer at NN Investment Partners.

“In the end, what you see in France now is a derivative from the so-called peripheral countries,” he added.

Graphic - France's debt levels exceeds that of "core" euro zone countries: here

Reporting by Dhara Ranasinghe and Abhinav Ramnarayan; Additional reporting by Karin Strohecker; Editing by Sujata Rao and Hugh Lawson

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