French bonds: a lesson in selectivity

The French bond sell-off illustrates how competition for capital is reshaping fixed income markets amid a global rate reset. Rising government borrowing and AI-related investment are pushing up financing costs, exposing borrowers with deteriorating fundamentals to greater scrutiny. At the same time, higher yields bring more opportunities: more than 80% of global bonds now yield above 4%, versus 6.3% five years ago. See the chart. France shows why selectivity matters across fixed income though. Its 10-year yield has jumped about 100 basis points since early August to nearly 5%, reflecting the broader rate reset. Yet the widening spread over German Bunds shows investors are also demanding additional compensation for France's fiscal and political risks. This underscores why investors need to distinguish between the forces driving yields higher.

Spillover risks from France warrant close attention. But today’s starting point is materially different from that of the 2011-12 euro zone debt crisis. France’s government debt has surged from roughly 89% of GDP in 2011 to around 119% today, while the euro area’s aggregate debt ratio is now back at its 2011 level of around 89%. The region is also better equipped to weather financial stress, with stronger banks and more powerful European Central Bank tools, though intervention isn’t guaranteed. Further volatility and spillovers remain possible. But indiscriminate selling could create opportunities in markets such as Spain, where fundamentals may not justify higher yields. For now, we stay neutral on euro-area government bonds and prefer opportunities elsewhere.

Looking elsewhere for yield

We see opportunities where higher sovereign bond yields better compensate investors for risk without signaling weaker fundamentals. We upgraded U.S. Treasuries as higher starting yields provide a bigger cushion against further rate increases. We also see scope for markets to unwind excessive Fed tightening expectations. Japan offers a similar example of shifting value. Long-term government bond yields have climbed above 3% and the term premium has normalized, improving the risk-reward balance as much of the yield adjustment we anticipated has now occurred. That prompted us to trim our underweight, even as we expect further upward pressure on yields as monetary policy normalizes. We favor emerging market local-currency debt, particularly in Latin America, where improving fundamentals and finances support attractive yields. Across fixed income, we see a rise in term premium, particularly if driven by fiscal concerns, as a key risk that could push yields higher.

The same selectivity extends to corporate bonds. We favor a reverse barbell approach, seeking attractive income in higher-rated high-yield bonds while avoiding risks at either end of the credit spectrum. Heavy AI-related issuance is putting pressure on investment-grade bonds, while the weakest borrowers face greater refinancing challenges as rates stay elevated. Higher yields mean investors no longer need to reach as far down the credit spectrum for income.

Our bottom line

France’s government bond selloff comes amid intensifying competition for capital that’s prompting investors to take a closer look at the source of higher yields. We favor select sovereign bonds and credit.

Concerns over surging AI-driven capital spending weighed on tech stocks last week. The S&P fell 2% while the Nasdaq slumped nearly 5%. U.S. 10-year Treasury yields briefly touched 5.34% after a hot September CPI print before retreating during the tech sell-off, though they remained up on the week. These moves reflect two key questions hanging over markets: the outlook for interest rates and the pace of the AI buildout. We still favor AI within our neutral stance on U.S. equities.

We look toward a fresh reading on UK price pressures after the latest U.S. inflation report suggested price pressures remain broad-based rather than driven solely by energy costs. UK data may reveal whether those pressures are broadening beyond the U.S. We are also closely watching Moody’s scheduled review of France’s credit rating as investors assess the country’s fiscal challenges and whether they have broader implications for the euro area.