The risk of sell-off is far from over; French bonds face potential rating downgrades, with key decisions to be made by Moody's and S&P.

The risk of sell-off is far from over; French bonds face potential rating downgrades, with key decisions to be made by Moody's and S&P.

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After a brief respite, uncertainty is once again rising in the French bond market. In the next six weeks, Moody’s and S&P Global Ratings will conduct key reviews of France’s sovereign credit, and these two decisions could reignite turbulence in European debt markets.

France’s heavy debt burden and turbulent political situation are putting enormous pressure on its fiscal credibility. Although French Prime Minister Attal survived two no-confidence votes this week, temporarily stabilizing the political situation, this crisis has also exposed the compounded risks of France’s fiscal and political vulnerabilities.

Currently, both Moody’s and S&P assign France’s sovereign debt their “lowest level double-A” ratings (Aa3 and AA-, respectively). However, another agency, Fitch, has already downgraded France below AA this year. If Moody’s or S&P follow with a downgrade, French bonds would officially drop out of the “double-A club,” triggering passive selling by some funds.

According to Bloomberg, large asset managers such as BlackRock, Vanguard, and Legal & General allocate some funds exclusively to sovereign bonds rated “AA or above.” If France loses this rating threshold, such “ratings-constrained investors” will be forced to reduce their holdings.

France is currently the largest sovereign bond issuer in Europe, with debt close to 3 trillion euros, making up a crucial share of the eurozone government bond market. If a downgrade triggers forced institutional selling, it will inevitably have spillover effects across the entire European debt market.

Eighty percent of institutions bet on a downgrade before the end of the year

Market concerns have already been reflected in bond pricing. The spread between 10-year French and German government bonds has widened to about 77 basis points, close to last year’s post-election highs. Yields on French government bonds have at times matched those of Italy, even though Italy holds a lower credit rating—indicating the market has partially priced in downgrade risks.

A recent survey by Societe Generale showed that nearly eighty percent of institutional investors expect that at least one of Moody’s or S&P will downgrade France by the end of the year. UniCredit economist Tullia Bucco pointed out,

“If France suffers a further downgrade, demand for OATs (long-term French government bonds) from foreign central banks will decline.”

These “super high rating” investors include global central bank reserve managers and pension institutions, who are extremely cautious in their allocations.

Political compromise for stability makes fiscal consolidation even harder

The Attal government this week postponed pension reform legislation in exchange for the Socialist Party’s support, avoiding early elections. This move allowed markets a brief sigh of relief, with French government bond prices seeing the largest single-day gain since July.

But this political compromise also weakens the prospects for fiscal tightening. Moody’s had previously warned that if pension reforms are withdrawn, it would be seen as a “credit negative” event. This means that short-term political stability may come at the cost of long-term fiscal trust.

France’s fiscal deficit is already at 5.5% of GDP in 2024, exceeding the EU’s stability standard of 3%. Moody’s will announce its rating decision on October 24, while S&P will review on November 28. S&P currently maintains a “negative outlook” on France; if a downgrade happens before year-end, it could coincide with the tight year-end rebalancing period and amplify market shocks.

The “domino effect” of passive funds

A potential downgrade threatens not only France itself, but also a range of ETFs and passive funds tracking “AA or above” indices:

  • A Vanguard long-term euro government bond index fund (EUR 675 million in assets) has a 37% French weighting;
  • Legal & General’s high-grade euro government bond fund (EUR 221 million in assets) has nearly 30% French weighting;
  • In VanEck’s high-grade short-term debt ETF, France also accounts for around 30%.

In addition, BlackRock’s iShares Global AAA-AA Government Bond ETF currently allocates about 10% to France. Its tracked index caps the weighting of any single AA-rated issuer at that level and entirely excludes lower-rated sovereign debt.

In contrast, UBS’s “high grade” product line includes several actively managed funds, such as a EUR 947 million fund investing in long-term euro-denominated bonds and a EUR 615 million fund focused on short-term bonds. The fund’s prospectus states these products “mainly invest in AA or AAA bonds,” referencing Bloomberg indices with a minimum standard of AA-. As actively managed funds, they are not bound by index weight changes like passive funds, so their managers have greater flexibility in the event that France is dropped from a benchmark.

Although some funds state they will “seek to match the index” and enjoy some operational flexibility, benchmark index adjustments still require funds to passively reduce positions in the short term. This means a downgrade could trigger structural selling pressure rather than just emotional volatility.

France’s predicament is not unique. Globally, the supply of high-grade sovereign debt continues to shrink. The U.S. lost its last remaining AAA rating from all agencies in May, leaving Germany and the Netherlands among the few nations still holding “triple-A” status.

Against this backdrop, if France drops out of the AA range, the global safe asset pool will shrink even further.

UBS France Chief Investment Officer Claudia Panseri pointed out:

“If France’s average sovereign rating declines, investors will demand a wider risk premium on French debt, which could trigger a round of passive selling by ratings-constrained investors.”

Risk Warning and DisclaimerThe market carries risks, and investment must be approached with caution. This article does not constitute personal investment advice, nor does it take into account the specific investment objectives, financial circumstances, or needs of any particular user. Users should consider whether any opinions, views, or conclusions in this article are appropriate for their particular circumstances. Investments made accordingly are at your own risk. ```