In recent weeks, we have regularly heard that the rise in interest rates on German and, by extension, French bonds was a major opportunity to invest in government bonds because they represent ‘absolute security’, ‘the risk-free asset’, sometimes even with the supposedly unstoppable argument ‘if the French state defaults, we will have other problems’.

We do not agree with these points of view for several reasons:

1. Interest rates have not risen enough
2. Germany's recent interest rate hike is not related to macroeconomic data (such as inflation or growth) but rather to credit
3. A bond investor does not necessarily need a bankruptcy to lose money or earn much less than he could have
4. A State does not need to ‘default’ in order not to repay its debts
5. In the event of a State default or ‘near-default’, not all companies and households in the country will necessarily default, and thankfully so... Of course, other problems will arise, but by refraining from lending to it, we will have preserved our capital a little better all the same! which is the objective of any asset manager, especially a bond manager...

Let's go back to these five points to support our point of view:

1. The rates have not risen enough

The reaction was an initial market reaction, linked more to derivatives and ‘fast money’ than to the groundswell that will occur later in the European sovereign bond market. This groundswell will see, on the one hand, colossal amounts of new bond loans taken out by governments, led by France and Germany, and on the other hand, financial markets that will eventually struggle to absorb them for three reasons:

• Reduction in the liquidity of central banks, which is expected to continue for a few years.
• Increased selectivity of investors, especially international investors, in European sovereign debt
• Finally, seeing so many institutional investors rushing to buy government bonds today, one can imagine that they will have less money for these investments later on, especially if rates continue to rise and therefore there are significant unrealised capital losses in portfolios, although most institutional investors never account for these capital losses and think in terms of pure yield and redemption value – a method strictly prohibited in investment funds but authorised in Euro funds and pension funds ... -.

The phenomenon of upward pressure on rates, and therefore volatility and rates above 3% or 4% on European sovereign bonds could, in our opinion, last between five and ten years, driven by the need for States to borrow massively, the ECB's desire to ‘let it be’ to rebalance the economic weights, debts, budgets and living standards between core countries - primarily Germany and the former peripherals. But also the gradual disaffection of international investors for European sovereign bonds in favour of other areas, particularly emerging ones that are gradually becoming ‘emerged’ and with better budgetary and economic balances than the Euro Zone. Currently, we consider that the German 10-year risk is only ‘profitable’ for an investor from a rate above 3.5% and that the premium of France compared to Germany, because its risk is much higher, should be above 100 basis points, i.e. French bonds should offer a minimum yield of between 4. 5% and 5% yield for us to invest significantly in them. At this level, which is becoming dangerous from the point of view of interest rates and the runaway effect on deficits, we would probably see the ECB re-intervene to calm things down and we would have, at our side, the second most massive investor in the world, which would allow us to somewhat secure our investment. This is hardly the case at the moment and we therefore prefer to stay away.

1. The recent rise in German interest rates is not linked to macroeconomic data such as inflation or growth, but rather to credit

We often hear that it is currently preferable to acquire sovereign bonds because they are less risky than credit, which may make sense, all other things being equal. However, in the financial markets, although this disclaimer is written everywhere so that managers and other distributors of financial products - which we sometimes are too - can write a plethora of marketing arguments, nothing is ever equal otherwise! Neither in terms of time nor space... Buying German bonds at a better rate before the announcements of increased debt compared to German corporates could therefore have represented a ‘relative’ but not absolute opportunity at the time. Relative because, at the time, Germany would have offered a higher yield, but not absolute because we were still positioned directionally on the bond market on the one hand, and because we then saw that such an investment would have been overtaken by current events, with Germany announcing an increase in its debt, which increases its risk and, consequently, the yield premium demanded by investors.

This is indeed the point we wish to raise here: German or French government bonds have been offering higher rates in recent weeks, not because the rate balances – growth and inflation – have changed, but only because their credit balances have deteriorated. If we applied this to corporate credit, could we say that because a particular company is going to have to invest heavily in order to develop, financing this investment by significantly increasing its leverage, thus seeing its credit rating drop a few notches and its credit premium climb relatively by the same amount, that this is an obvious opportunity?

Not at all, the analysts would then write that the situation has changed, that the company is riskier and that the investment case must be reworked in the light of these new elements, bringing a lot of uncertainty since the company will have on the one hand a certain debt and on the other hand an action plan subject to the risk of execution for several years.

The crisis in peripheral countries at the beginning of the 2010s taught us, especially in Europe where countries no longer have control over their national currencies, that sovereigns are no longer ‘risk-free’ assets by nature and that it is important to consider them also from a credit point of view; a point that seemed to have been fully assimilated during the restructuring of the Greek debt but which now seems to have been forgotten, in the face of ‘apparently significant’ rates for a country that was paid to lend a few years ago...

1. A bond investor does not necessarily need a bankruptcy to fail to earn money or earn much less than he could have.

When you invest at 3.4% for 10 years in a bond (French rate at present), you can obviously tell yourself that you are certain, barring default, to earn it. This is true on the sole condition that you keep your bonds until they are redeemed, in all market configurations. Our assertion may therefore seem easy to counter and some investors will reply: ‘that's exactly my case and 3.4% over 10 years suits me perfectly’.

This is not so obvious when credit quality deteriorates and many investors during the peripheral crisis had to cut their positions due to credit ratings, excessive losses or volatility, or risk management decisions... This is also not so obvious when rates start to weigh on the valuation of other assets that become more attractive (real estate in a few years' time, for example) or require reallocation.

Finally, our argument is aimed more specifically at investors using funds and ETFs for their investments. While a fixed-term fund may make it possible to set a rate, most other funds, which are often benchmarked, and more specifically ETFs, which are widely favoured for investments in sovereign debt, must represent ‘the market’ at a given moment in time. Thus, every day an ETF must reallocate its portfolio over the average maturity of the debt of all the countries it includes, for example around 7 years for Germany or France, and eliminate the tails of distribution for the sake of efficiency, cost and liquidity. Thus, the maturity of a European sovereign ETF will never be reached and will roll over every year on a 7-year basis, or even tend to increase over time as new issues are made. Thus, an investor using ETFs will never have this force of recall at the maturity of a bond and may take much longer to obtain the initially expected return than by investing in a bond, particularly in a phase of sustained rate increases.

1. A State does not need to ‘default’ in order not to repay its debts

Because our weekly is already long and because Europe faced this scenario just ten years ago, we will not dwell on this point... But it is important to keep in mind that lending to a State is lending to the guarantor of the system, who also decides the rules of the system so that he can remain the guarantor... Once again, if we were to apply this to the corporate world, we would imagine a loan contract drawn up directly by the borrower and which can be modified at will, at any time.

This is more or less what happened with Greek bonds, which were not considered to be in default, but were not repaid either. Generally speaking, it is rarer to see formal defaults than restructurings of the coupon or duration, a phenomenon that can also be observed in corporate debt.

One could therefore imagine, for example, in a European country, seeing short-term debts converted into 100-year or perpetual debts, as Portugal did in the middle of the last century. We could mention the four perpetual bonds ‘Governo Portugues Consolidado’, issued between 1940 and 1943, with very moderate coupons between 2.75% and 4%, and which are still in circulation!

Another possibility would be a forced rollover of the bonds due to the unavailability of capital, and here we could mention the famous Sapin II law. While it may prove useful as a tool for the temporary stabilisation of liquidity for insurers, it can also be used for the financing of the State in the longer term.

By imagining a blockage of a few percent of the savings of Euro funds through mechanisms of exit quotas, taxation and regulatory constraints on investments, the financing of the French State would be greatly facilitated...

1. The systemic risk argument

Finally, the systemic risk argument, according to which we should invest on the basis that other problems would arise if it materialised, does not really convince us because it is only fair in a closed world, which is not the case in the contemporary world. Let us recall two points in this regard:

1. Back in 2014, our colleague Maurice de Boisséson at Octo Finances wrote in his editorial that the economic system depends not so much on the state as on the financial system, and that Europe, through the ECB and the European Commission, could very well accept a restructuring of the Greek debt but would never allow the Greek banking system to go bankrupt. This is precisely what happened and while the Greek government debt was restructured, Greek banks were largely supported by mechanisms for accessing liquidity from the ECB, despite their situation.
2. Bond issuers are generally large, internationally diversified companies with relatively sound governance. These companies, like investors, therefore also manage their country risk, and during the peripheral crisis, we saw less volatility in Italian or Spanish corporations than in their respective governments. Some companies based in Greece, such as Coca Cola Hellenic Bottling, even changed their country headquarters during the crisis to avoid suffering from this country risk. More generally, at the European or French level, if Total or LVMH are starting to look to the US these days solely for stock market or tax reasons, it is quite conceivable that a serious sovereign crisis in Europe would be a major reason for a shift...

It therefore seems to us entirely possible and preferable to avoid European sovereign risk today because it specifically only remunerates systemic risk while its credit risk is increasing sharply and durably. However, we also consider that corporate credit risk is less remunerated than it was, a fortiori on high yield, and that it is therefore preferable to be cautious also in this part of the market. We therefore continue to favour financials, and our point 5. 1 is entirely in line with this in the event of a worsening of the European economic slump, while maintaining a short duration, convinced that the issues of sovereign debt, geopolitics and undervalued risk premiums on many assets could come back to the forefront and offer significant bouts of volatility in the coming months, including sovereigns.