French Bonds, The Next Big Short?

Up, up and away. French bond yields rising. The higher they go, the worse it is for the French economy. Can the market handle French yields at 500 basis points over Treasurys? SW Asset Management in Calif doesn't think so. They're shorting French corporate and sovereign debt.

If the market was all of the same mind, French bonds would be the biggest short seller target in the months ahead. Yields would rise almost daily. Bond prices would start looking like 1990s Argentina. Whether or not the bears successfully take major bites out of French bonds next week remains to be seen, but for David Hinman and Ray Zucaro, co-managers at the $240 million SW Asset Management firm in Newport Beach, California, French assets are the next European asset to suffer.

France will join the rest of southern European government and corporate debt, inching into the realm of Third World status with its bond rating being cut. It�s prognosis negative in southern Europe and France is checking in to the emergency room.

When financial news media were focused on Greece and Italian sovereigns, Hinman was busy building his short position against Spanish bonds in the Forward Global Credit Long/Short fund (FGCRX) it runs for Forward Management, a $5.1 billion investment company in San Francisco. �We are moving down the line. Our favorite short in Europe right now is France. Italy is a tight call. We think there is more upside if you short France. Yields are going to go higher there,� Hinman says.

Short sellers agree to sell the bond at the current price expecting the bond to be worth less so they can buy it at a discount. Selling a French bond priced at 99 and then buying it at 80 is a nice 23% capital gain.

Hinman expects rating agencies like Moody�s to downgrade French credit from its current AAA status at some point in the first half of 2012. The U.S. was downgraded on Aug. 5 by Standard & Poor�s, going from AAA to AA. U.S. Treasury prices actually rose shortly afterwards due to risk aversion in the high yield bond and in the equity markets. But France doesn�t have the luxury of being the world�s reserve currency like the U.S. dollar. A credit downgrade for France means its bonds will trade below par value, which means higher interest rates.

French credit default swaps (CDS) were trading between 236 and 241 points over U.S. Treasurys during Thanksgiving week. CDS are insurance derivatives against bond defaults, but they are mainly used in the market as a gauge on investor confidence in sovereign or corporate debt. As those numbers push to their levels ever, the market is thinking that France�s ability to pay its debt is dwindling. By comparison, Italy CDS are over 500 basis points over Treasurys. �The world has done okay with Greek, Ireland and Portugal bond spreads widening to astronomical levels. But it won�t handle Spain, Italy and France bond yields going higher. It�s going to spill over into other asset classes � corporate bonds, east European debt. We are seeing it already. The severity of French CDS� going from 220 to 500 is going to be very meaningful and it could very easily happen. There is too much debt with very little prospects for them being able to work it out. I am not sure how all of this plays out.�

Yields on Italy and Spain 10-year bonds are over 6%. That means the government has to pay higher interest rates on its bonds. But how does it pay higher interest rates when it is running deficits and the tax base barely enough to pay rates at previous levels? Both countries have to borrow short term to pay for government obligations, from keeping the lights on at federal buildings, to government pensions and aid to states. Even if these countries had no debts, the fact remains that both spend more money than they earn from taxes and investment income.

Troubled credit tends to hit inflection points. What day you�re at 6.5%, and the next day the house of cards collapses. Some government leader says something wrong. Some big bank starts dumping its bonds at a loss, and then you�re at 12%. That�s one of the main concerns of the European bond market at the moment.

�The major institutional holders of these bonds are not prepared for what is going on,� says Hinman. �They were never prepared for this kind of loss on investment grade, low yield debt. It�s unheard of. It�s something you�d expect from single B junk bonds. So the institutional investors never factored in the possibilities of real loss on their investment. Big gaps in prices are not what holders of developed economy debt ever expect,� he says about bonds that normally trade at par value of $1,000 or more, now trading below that�and falling.

There is not a corporate or sovereign bond in Europe worth owning, Hinman says. �Our primary concern now is what�s going on in Western Europe. It�s not getting to a point where we�re seeing knock-on effects to Eastern Europe. Suppliers of credit in the west are no longer participating in Eastern Europe because they need the money at home.�

What does that mean? It means if you�re an oil company in Kazakhstan, a country not known to be cash rich, your reliable Western lenders are no longer reliable, even if you�re credit rating is investment grade.