The investor’s best friend at the moment

French fiscal stress pushes up risk premiums and tests European stability, although fixed income is regaining attractiveness as a safe haven for investors

Concerns about the eurozone’s sovereign debt are intensifying as problems in France remain unresolved by political disunity. The pressure is spreading to Italy, the euro and corporate credit.

Sovereign bond yields increase

The spread between the yield rates on the 10-year bond of France and Germany widened last week to 141 basis points, levels not seen since the 2012 Euro crisis when the epicenter of the crisis was the peripheral countries and there was a real risk of bankruptcy, particularly in Greece. whose risk premium shot up to 3500 points.

The trigger for what happened in France a few days ago was the French government’s 2027 budget proposal, which aims to reduce the deficit to 5% of GDP, and the doubts that its possible approval by Parliament inspire in investors. Italy’s spread with Germany also widened and the Euro depreciated by 1.2% against the dollar. Spreads on quality corporate bonds as well as high yield bonds also widened.

The environment has changed

No one doubts that, with the rise in bond yields, fixed income valuations in general have become more attractive. Nor do the markets question that a restrictive monetary policy stance by central banks, including the ECB of course, is going to be accentuated.

In this negative environment for sovereign debt, it is striking that many investors are not divesting from equities and that the US Nasdaq index is at record highs and not far from that record is the S&P 500.

Hence, there are analysts who believe that the problem of sovereign debt goes beyond the rise in its yield and that we are facing a potential solvency problem for governments that exceed reasonable economic, fiscal and inflationary limits with their debt.

In any case, the solvency of the large debt issuers, considered as the repayment capacity of the US and the main countries of the Eurozone, cannot be doubted only due to inflationary tensions caused by the rise in the cost of energy, which, on the other hand, reduces («cheapens») the real cost of this debt.

A different issue is the growing weight of debt and deficits of these countries with respect to their generation of wealth and tax revenues. There I think we can see a gap in the solvency of some countries, as US financing costs reach their highest level in 25 years and .

However, today in the US there is a very active Federal Reserve that has instruments to counterbalance excessive public spending policies that reduce the cost of debt (quantitative easing, for example) and, in Europe, the ECB has specific rescue funds to support countries (European Stability Mechanism) (rescue fund that grants financial assistance to states, but under conditionality) or its own quantitative easing (Transmission Protection Instrument) to lower the cost of financing states. The latter, and given that the mutualisation of the public debt of the Eurozone does not really exist, would undoubtedly penalise the price of the Euro, which has already been suffering for several months.

Beyond the fact that governments are now more aware of the need to channel public finances towards a sustainable path (the aforementioned possible bankruptcy of Greece brings back unpleasant memories), all of the above allows us to affirm that we are in a very different situation from that of fifteen years ago with the Great Financial Crisis.

The contradiction we face

However, I believe that, sooner rather than later, France will show a stronger will to lower its cost of financing and to rationalise its public finances in line with market demands. That is why I believe that the situation we are experiencing, without underestimating its seriousness one iota, should not make us forget the convenience of the presence of bonds within an investment portfolio.

I assure you that if there were a default by any of the aforementioned countries, the consequent financial earthquake that would take place would be of such magnitude that the least punishing the valuation of a portfolio would be the sovereign bond component. On the contrary, he would undoubtedly be the one who would best defend himself in that trance.

The key lies in the investor’s time horizon, which brings us to the conclusive fact that there are many reasons to maintain a strategic allocation in bonds. Risk premiums may continue to rise but, as in so many financial crises, the duration and magnitude of these increases, with subsequent falls in bond prices, will be temporary.

In addition, the inflation we are suffering will not be temporary, but this resurgence will not last forever since its causes are quite limited as I indicate above and bonds will continue to provide coverage in times of falls in the riskiest assets.

For all these reasons, I believe that it is a good time, especially in portfolios with a high weight of risk assets (especially the stock market), to, with the cautions expressed here, increase the weight of public debt in the portfolio at this time: withstanding the volatility of the short term, sovereign bonds will continue to offer protection when the equity markets fall and now count, due to the rise in their yields, with more capacity to do so. Patience and financial realism will be rewarded.