The French election is fast-approaching and the knock-on effect for the markets is growing, as right-wing candidate Marine Le Pen's role becomes more prominent.
This week German bond yields fell to record lows of -0.92% on French election worries, with investors buying short-dated German debt and forcing yields down as currency fears enhanced.
These major market moves come in the wake of investors highlighting earlier in the year that Europe could face its own taper tantrum as European inflation rises.
As market jitters continue ahead of April's first round of votes, Citywire Selector spoke to leading bond managers to see how they are positioning their portfolios.
Beware the bombshells
Andrew Johnson, head of global investment grade fixed income at Neuberger Berman, said the team has been reducing French exposure since the fourth quarter of 2016, in response to what they perceive as potential disruption caused by the election.
Quite frankly, at the levels where we started to put the trade on we didn’t think the yield to the German bund could contract but it could go the other way and that is an example of the asymmetric traders we look for.
In our Global Absolute Return fund we started to take that off and bank some of the profits more recently as we approach the event but we are seeing scandals about the candidates on an almost daily basis, so it is difficult to call.
We could see some bombshell about Marine Le Pen and then the risk element wouldn’t be as great but she could be like Trump – who actually said he could shoot someone in the street and not lose the election during his campaign – but we wait to see.
To give you an idea of how the market is reacting, the German bund and the French 10-year has got out to 75bps and last year it average 37bps. So it is about three standard deviations from where it was, could it get to four? Theoretically yes but I wouldn’t want to say. It does show the scale of the moves and that is why we have our eyes on it.
Citywire A-rated Tatjana Greil Castro, portfolio manager at Muzinich & Co., said she has been underweight French bonds for several years due to them constantly trading tight versus their credit quality.
This tight trading is particularly true for French investment grade bonds, which are generally very well supported by the French domestic investor base.
With regards to French high yield bonds, the investor community holds more cautious views due to the unfriendly nature of the French insolvency regime towards debtors. We generally take the view that French high yield companies must be considered creditworthy, with only a remote risk of a restructuring, before we would get involved.
So far during the election campaign, we have seen French government bonds trade wider against the Bund – arguably on the basis of political risks. We have not experienced the same widening of French corporates. This may be partly due to the fact that euro-based corporate bonds price over the Bund rather than over their respective government curves.
Should there be a win of a less European-friendly president in France, we would expect some underperformance of French credits. However, it should also be noted that it is the presidency where the Front National has an outside chance of winning.
It is even less likely the party could win broad support to form a government in the election that follows right after the presidential vote.
Don't discount anything
The electoral system in France does make it tougher for someone like Le Pen to win an election. She might have a hard core following of 25% of the country, but that’s not enough to get her over the hurdle of the second round.
Given what we saw last year I suspect that markets will overprice Le Pen risk, just because they under-priced risk last year.
We had some very positive PMI data from France this week and once we get through this political hurdle, it seems markets will start to focus again on the ECB and any potential tapering.
All eyes on the ECB will be a negative thing as they gradually move away from the bias they have been in. They have been such a big buyer of French bonds, that technical support with start to diminish, which will effect France more than other countries.
The fundamentals of France are still not that great, even if you think Le Penn is a low probability event, I still think there will be a French rally after Le Penn loses the second round. Nonetheless, France will come under the spotlight again later this year because of the ECB.
We have become increasingly more negative with our allocation to French government bonds. In our fully flexible strategies, we are outright short French bonds.
The catalyst for our outlook change was Trump's victory in the US. We witnessed the rising populism that carried Trump's victories and drew many parallels to the policies of Le Pen. His victory was supportive for Le Pen's probability of winning the upcoming French election.
Since the US elections, the extra yield premium that investors require to hold French government bonds relative to German government bonds has increased from 0.30% to 0.80% - levels not witnessed since 2012.
Where we prefer to hold French exposure is in non-government bonds such as banks or corporates where the threat of re-denomination is less.