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Last Monday, the Wall Street Journal had a front page heading, “Europe’s periphery debt market welcomes new member: France”
Last week we once again saw relative volatility in sovereign yields, particularly in France, where a flood of election polls caused significant changes in borrowing costs.
No longer just tagging along with Germany, France is now in the spot light and its recent spread widening is just a foretaste of the dramatic shocks possible in the weeks to come.
Although, so far, the situation is different from the peripheral spread widening in 2011/2012, it has relatively similar to 1/ the concern in Spain when the Podemos [We can] party was at the height of its popularity and made it impossible for Mr. Rajoy to form a government, and 2/ the period leading up to the 2016 Italian referendum.
We think that for French rates, the year 2017 will separate into two distinct periods:
  • The first is relatively obvious and consists of a period of high volatility (in the knowledge that a 0.1% change in the yield equals a bond price change of almost 1%, the equivalent of one year of return earned from buying and holding the same bond) in response to announcements of back room deals and poll results, in the context of a continual spread-widening related more to the uncertainty associated with the vote (unexpected 2016 ballot results) than to the content of candidate programmes or the polls.
  • The second is much more uncertain as it would be presumptuous to consider as a given, the market’s reaction to the election to the presidency of any one of the candidates, as the US election of Donald Trump showed. But, the uncertainty could increase further between the presidential election and the legislative election, particularly if the presidential election leads to a President who has little support from a mainstream party and/or is considered too extreme to be able to form a majority with ease.
As a result, we will not dare to make any prognostications or assume an unwelcome political position in our Weekly note. But we consider that there is a risk of capital loss and major volatility. In consequence, it would be advisable:
1/ to hedge positions related to French bonds via a future’s contract on France’s 10-year government bond (OAT). Created in 2012, this contract caused a stir amongst some of the candidates to the current presidency. And, although the French OAT futures is not all that well known and slightly less liquid than its peer, the German Bund futures, it still serves a purpose and can be used to hedge (a) those financial notes which are heavily connected with sovereign issuers, as we saw in the last few days when Tier 2 bank bond spreads widened dramatically in parallel with the OAT (totally illiquid at the beginning of the week), (b) high grade corporate bonds which have particularly low credit premiums, particularly, non-cyclicals. We recall that, during the period 2011-2012, Italian and Spanish utilities or telecom bonds whose credit quality was totally acceptable, even better than that of certain French or German corporate bonds, whose yields fluctuated between a range of 6%-8% and they had difficulty maintaining their IG rating.
As liquidity shrank, the ranges widened and, as corporates often serve as buffers against sovereign bonds in the event of sovereign crises (regionally diversified issuers, reliable management, more healthy balance sheets, issuers in the incapacity of taking unilateral decisions), hedging by using OAT futures rather than selling the notes can even create additional performance , in the event of massive sell-offs. The situation of Greece clearly demonstrated that the government had defaulted whereas most of the country’s banks and corporates hung on in there. Long/short sovereigns/corporates … they were all a winning bet.
2/ to sell the least liquid positions immediately as their prices often lag behind so, despite their connections with France, they may not have followed the recent trend towards widening. When this happens, they generally catch up all of a sudden and, with the help of underlying illiquidity, in considerable proportions.
3/ to offset French positions by taking on significant exposure to other countries or complementary asset classes, such as HY Although, in absolute terms, cash provides an excellent hedge, as we have said in the last few months, cash will never rise when French positions fall so will not allow for offsetting losses, only reducing them.
We believe that the French sovereign will widen against its peers in Europe, in the ST, owing to the forthcoming elections, and the LT, as the country’s budgetary situation is deplorable. Moreover, the situation is automatically worsened when interest rates rise as each rate increase of 0.1% represents an additional charge for the budget of €2bn. We propose the following for the most active investors and who are prepared to short sovereign debt: they could acquire a basket of semi-core/semi-peripheral eurozone bonds, made up of the main drivers, Germany, Spain, Portugal and Italy, and sell the OAT futures for an equivalent size. As a result, they will hedge the absolute risk residing in exposure to yields and be exposed only to the spread existing between French government bonds and the eurozone bonds in general. This strategy can be used throughout the bond universe and leads to returns without structural exposure to an over-priced asset class.


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