French government debt sparks credit concerns
This quarter has seen significant economic events, including a notable move in French government yields. The risk associated with these yields is best illustrated by comparing the spread of the 7-10 year France government bond index to an equivalent maturity, BBB-rated, corporate bond index. This spread has collapsed, with the two now trading side by side, according to data from M&G/Bloomberg.
The market convention categorizes bond asset classes into three groups: government bonds, investment grade, and high yield. Government bonds are traditionally viewed as free of credit risk, while investment grade bonds have limited credit risk and should remain stable in an economic downturn. High yield bonds, on the other hand, carry more credit risk and are potentially vulnerable.
Within the government sector, the G7 is traditionally seen as the risk-free benchmark. However, the credit ratings of the G7 have shown a slow but persistent deterioration in credit quality since the turn of the century. This is evident in the average rating of S&P, Moody’s, and Fitch, which has declined over time, according to data from M&G/Bloomberg.
The deterioration of government finances can be attributed to various factors, including the financial crisis, recession, and COVID response. However, governments have increasingly lacked the fiscal discipline to repair the damage once the storm has passed. French government debt, for example, has shown a steady upward trend with step-ups for spending through economic shocks, as illustrated in the chart below.
The chart covers over 40 years of rising debt, and reversing this trend would require a sustained period of fiscal discipline. This may prove difficult to maintain through several election cycles. If a company managed its finances in a similar manner, shareholders would eventually provide the necessary discipline. With governments, management is effectively the politicians, and the shareholders are the voters. France may regret its fiscal position, but what is it prepared to do to solve the problem? 1) Is French debt cheap relative to French corporates? 2) Are French corporates better quality and should trade through governments?
