Are french OAT overvalued ?

According to John Gilbert, CIO of the Berkshire Hathaway’s subsidiary General Re-New England AM, French 10-year bonds should yield between 4.5% and 5%, closer to Italian and Spanish bonds rather than German ones. However, This opinion is not shared by the majority of the fund managers interviewed ...

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With the downgrade of France’s rating early in the year, people predicted the worst for french debt market. However, nothing happened so far. The borrowing cost of France have not soared since the loss of its triple S&P’s AAA rating. Actually it is quite the opposite. As surprising as it may seem to some observers, investors are now willing to pay in order to to lend to the French State.

One must note that during the summer, some BTF (French Treasuries) were issued by the AFT (Agence France Trésor) at negative interest rates for maturities of several months. Clearly, investors who bought these securities will receive - at maturity - an amount less than the one originally invested!

It makes one wonder if investors have already forgotten that France’s debt, according to INSEE, reached 1789,4 billion at the end of the first quarter of 2012, nearly 90% of its Gross Domestic Product (GDP), an increase of 3.3 points versus previous quarter figures.

According to Frederick Solomon, Schelcher Prince’s fund manager, "The french bonds negative yields are explained by systemic risk aversion linked to the debt crisis in southern countries of Europe". Indeed, despite the issues in public finances, "The credit quality of France is still one of the best of the Eurozone and therefore France bonds are considered to be safe havens" he adds. Eric Bourguignon, the head of fixed income and credit management at Swiss Life Asset Management, says "many investors find more interesting to pay a little cost to secure their capital by investing in safe assets rather than trying to make profits by buying debts whose repayment is unlikely. "Thus, the sustainability of negative yields on short-term French bonds reflects the confidence level on our debt".

Indeed, the bond markets clearly see France as a safe country within an eurozone currently undergoing turbulences which raise investor concerns about the financial situation of some countries in Southern Europe, such as Greece, Portugal, Spain or Italy.

This feeling is shared by fixed income market professionals we interviewed, both in France and abroad. They all agree, including Lazard Frères, Sycamore AM or Petercam in Belgium, that despite the observed yields on the French debt, we are not yet in a bubble in this market, with regards to BTFs.

According to Benjamin Le Roux, Lazard Frères Gestion’s Head of Fixed Income, ’The assessment of the relative value of French government bonds should be based on a scenario even though the current situation of negative yields remains atypical. In case you consider that France will be able to reassure financial markets on its ability to meet its commitments in terms of reducing its budget deficit, it is conceivable that current yield levels remain stable, particularly in case of further key rate reductions by the ECB ’.

However, these professionals seem reluctant to buy French debt given the low levels of yields.

It is the case of Swiss Life Asset Management or even Sycomore AM who tend to favor corporate bonds which offer better return prospects, especially in the High Yield compartment. Indeed, "once removed the anticipated level of inflation in the coming years, the net yield of 10-year OAT - fungible treasury bonds - is close to 0" adds Emmanuel Sinety, manager at Sycomore AM. In short, not enough to attract fund managers

However, some are forced to keep a given level of "tracking error" relative to their benchmark, including Carl Vermassen, the fund manager of Petercam Bonds EUR. His objective is to outperform the JPMorgan EMU Government Bond Total Return. This suppose to hold somehow french government bonds, regardless of the price. However, given the current levels, he deliberately chose to reduce its exposure to French OAT to 19.3% against 24.7% for the benchmark as of july 31st, 2012.

In short, the managers interviewed do not currently seem to increase their allocation in OAT. It is not excluded that the latter will face speculative attacks in the near future if the budgetary efforts of France are not met, as Frederic Salomon said.

"Investors should be wary because French companies have lost competitiveness over the last decade and labor costs are higher than in Germany" warns John Gilbert, CIO of General Re-New England Asset Management, a subsidiary of Berkshire Attaway, the financial arm of billionaire Warren Buffett. "We do not know if the market will change its outlook on France", says Gilbert. "It is possible that France continues to benefit from the large size of its bond market, which is sufficient enough to absorb the flow of sellers, but 10-year bonds should yield about 4.5% to 5%, closer to Italian and Spanish yields rather than German ones", he warns.

Other factors could also help increasing the yields of french government bonds. Setting a target rate ceilings for Spanish and Italian bonds by ECB’s Mario Draghi could restore confidence and encourage investors to reallocate investments on peripheral sovereign bonds.

On the other hand, French OATs like German Bunds and Dutch bonds have performed tremendously since the beginning of the crisis and some investors, including Swiss Life, are starting to take their profit. "In May and June, we sold for CHF 7.8 billion (6.5 billion euros) in eurozone government bonds (mainly France, Germany, Netherlands) and realized a gain of CHF 0.9 billion (0.75 billion euros) ", said Thomas Buess, CFO of the swiss life insurer which move from CHF 6.096 billion (5.08 billion euros) of French bonds held in late 2011 to CHF 3.376 billion (2.81 billion euros) as of 2012 june end. OATs are nevertheless the largest portfolio’s holdings amongst eurozone sovereign bonds of the insurer.

German bonds holdings rose from CHF 4.57 billion (€ 3.81 billion) to CHF 1.68 billion (€ 1.40 billion) and Dutch ones rose from CHF 1.90 billion (€ 1.58 billion) to CHF 1.26 billion (€ 1.05 billion).

The life insurer bet now on T-notes

U.S. bonds holdings rose from 2% to 18% of its sovereign bond portfolio, moving from CHF 0.762 billion (€ 0.635 billion) at the end 2011 to CHF 7.590 billion ( € 6.33 billion) as of 2012 june end.

RF September 2012

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