November 2012

FRANCE: The curious incident of the fall in bond yields

ArchWith France a major player in the eurozone crisis, George Mitton asks what the country’s asset management industry is making of a new president and of bond yields that don’t do what they ought to. In November 2011, traders watched the worsening European debt crisis with foreboding. Many of them feared France would be next in line to be punished by the bond markets. Yields on French ten-year government bonds peaked at 3.7% that month, and the spread against ten-year debt issued by Germany, the safest European sovereign issuer, reached a high of 147 basis points. There were good reasons to fear that France would suffer. Its public debt was 86% of GDP, greater than that of Spain, whose ten-year bonds have since peaked at yields above 7%. Soon after, in January, ratings agency Standard & Poor’s stripped France of its AAA credit rating. And yet the dreaded spiralling in French bond yields never happened. In August this year, yields on French ten-year bonds reached a record low, of slightly above 2%. Spreads against German bonds narrowed to about 60 basis points. Observers were left scratching their heads. Unlike the troubled southern European countries, France had not begun structural reforms to reduce its deficit, and still hasn’t. Indeed, in May it elected François Hollande, who talked during his campaign of raising taxes and increasing government spending. Soon after taking office, Hollande lowered the retirement age for some government workers to 60, at a time when many developed countries planned to put their retirement age up. Strong bloc
Supporters of former president Nicolas Sarkozy had argued that Hollande’s policies would alarm the bond markets and cause the country’s borrowing cost to rise. And yet the opposite occurred. What happened? In a word, distortion. Bond managers and economists say that yields on French government bonds do not reflect economic fundamentals, but that the country’s position as part of “core” Europe has bestowed on it the gift of low borrowing costs, which are perhaps not deserved. The source of the distortion is, of course, the eurozone crisis. Yields on French government bonds are not at their natural level, explains Pascal Blanqué, deputy chief executive at Amundi Asset Management. Many investors are not buying French government debt because they are bullish on France, but because the country is associated with Germany, the Netherlands and a handful of other northern states, which make up a financially strong bloc that counterbalances the troubled peripheral states. “If you have to buy European bonds, you buy the core,” says Blanqué. “Part of it is captive demand, irrespective of fundamentals, whether perceived as good or bad.” Among the core issuers, France is popular because there is a large pool of French government bonds and the market for them is highly liquid. There are few alternatives. German bunds are expensive. French bonds are overpriced too, but not by much. For institutional investors that have to have a position in European bonds, French debt is an acceptable compromise. The low borrowing costs in France have had helpful consequences for Hollande. According to one view, they have allowed the government to delay the structural reforms that many people think it needs. These are reforms such as reducing the pensions burden and making the labour market more flexible and specialised. Some think this delay is ultimately unhelpful. Blanqué comments that there is “some complacence” contained in the French yield curve. Austerity
On the other hand, Hollande has gained considerable political capital from his pronouncements that growth, not austerity, is the solution to the eurozone problems. Hollande does not want to choke off what growth there is in France by applying harsh austerity measures, at least not yet. There may be some sense in delaying the structural reforms that many economists and fund managers would like to see. It is a balancing act, though. Hollande must also reassure investors that he can tackle the public deficit. The government recently reaffirmed its commitment to a public deficit of 3% of GDP in 2013, down from 4.5% this year. This target has become a flashing light to the bond markets, which could kick back against French bonds if it is not met. Xavier Denis, chief economist at Societe Generale Private Banking, says Hollande must strike the right balance between remaining credible in terms of fiscal adjustment and avoiding a lingering recession. Structural reforms
Hollande has room for manoeuvre, though. There are different ways to approach the deficit. There is evidence that the significant short-term fiscal tightening in the UK, Spain and other peripheral nations has killed off growth, says Denis. Hollande’s emphasis on reforms that will create savings, not right away but, in the medium and long term, may be wise. “Almost all countries need some structural reforms,” says Denis. “The question is, should we have, right now, some front-loaded fiscal adjustment, or is it preferable to have adjustments back-loaded, with a stronger focus on structural and policy reforms in the labour market and on public pensions, that could pay off not in one or two years but over the coming decade?” Most analysts agree that Hollande hit the right note when he talked after his election about growth being the solution to the European problems, not austerity. It marked a change in the crisis. Olivier de Larouzière, managing director of European bonds at Natixis Asset Management, says Hollande’s speech put him in a position to challenge Angela Merkel’s leadership of the events in Europe. Germany’s Merkel had been the strong leader in 2011, he says, but her influence has seemed to diminish this year. This kind of shift in the power balance has become increasingly important for bond investors, says Larouzière. The political aspects of bond investing have become as important as economic analysis and he now visits governments to try to understand their strategies, just like a corporate bond investors would visit companies. Overweight
When Funds Europe visited Larouzière in September, he was overweight on short-term debt from some peripheral countries such as Spain and Italy and underweight on short-term debt from the core. He was overweight on some core countries’ long-term debt, such as Belgium and France. “You look for yield pick-up in the core on long-term bonds and for risky countries on short-term,” he says. Since yields on French ten-year bonds reached their low in August, they have stayed not far above 2%. Of course, this is partly due to the effects of the European Central Bank’s bond-purchase programme. But the low yields are also, in a way, a vote of confidence in Hollande. This will be particularly welcome seeing as a poll recently indicated confidence in him among French voters fell from 54% in August to 43% in September. Many people in France say the fears about Hollande pursuing a leftist agenda were misplaced. He is quite simply not as radical as he made out during the campaign. “He promised quite a lot, but a lot of promises during election time will be forgotten,” says François Hullo, chief investment officer, fixed income and money markets, for BNP Paribas Asset Management. The lowering of the retirement age to 60, though it raised eyebrows abroad, was not significant because it only applies to those who started working aged 18. “Lots of things in the campaign were cosmetic,” he adds. ©2012 funds europe

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