Bond managers raise alarm about France downgrade

Amid Ireland’s potentially terminal bank bailout last week, another eurozone woe passed relatively unnoticed: bond managers say France may be the next state to be downgraded.

Lucette Yvernault
Lucette Yvernault

Christophe Akel, a co-manager of the GLG Global Corporate Bond fund, revealed GLG already considers a downgrade a possibility and has gone long German credit default swaps and short French credit default swaps in its hedge funds. The cost of insuring French debt is only 30 basis points higher than the cost of insuring German debt. In Akel’s view the premium should be larger.

The manager has shied away from defensive corporate bonds which trade at lower yields than French government debt, including France Telecom, as they will be sensitive to a spike in French yields.

According to Akel, a France downgrade could have a wider effect on eurozone government debt as “it’s supposed to be one of the two countries bailing out Europe”. (article continues below)

In particular, the AAA rating of the European Financial Stability fund (EFSF) depends on extensive backing from AAA issuers, which would diminish if France were to be downgraded.

Investors are worried authorities may have to deploy the fund in the event of a bailout of peripheral states like Ireland. Ireland, which recorded negative growth in the second quarter following an austerity package, is running down cash to bail out its banks and avoid relying on international lenders.

If the EFSF has to bail out Ireland and calls on funds from France, the case for a French downgrade may strengthen. Conversely, if France is downgraded, the EFSF’s ability to bail out Ireland will be limited.

Lucette Yvernault, a global credit portfolio manager at Schroders, which criticised the make-up of the EFSF last week, says France faces problems cutting its 8-10% budget deficit because President Nicholas Sarkozy’s party no longer controls the Senate.

The country also faces off balance sheet pension liabilities and declining contributions to its national pension plan, she says.

“The population is ageing in France and contributions to the state pension plan are not rising. It’s not surprising that lengthening the number of years’ contribution to the pension plan is being discussed.”

Yvernault compares the situation to the banking crisis of 2008, when the French government attempted to reassure the population the problems originated in America and were unconnected to France.