French sovereign risk: what markets are really telling us

Recent chaotic developments in France's political landscape have become impossible to ignore. The resignation of Prime Minister Lecornu – the latest in a sequence of ministerial departures – and his subsequent return created considerable uncertainty for investors. Beyond the significant societal implications, the situation calls for a careful reassessment of France's sovereign risk profile. This is particularly significant as foreign investors hold about half of all French sovereign debt instruments. 

Currently, France maintains a median rating (commonly referred to as an index rating) of AA-, but it is worth questioning whether current market valuations accurately reflect this. And if market sentiment diverges from official assessments, to what extent is France's creditworthiness being discounted? This analysis is particularly nuanced, as sovereign spreads typically incorporate forward-looking perspectives. Formal ratings downgrades often merely confirm what market participants have already priced in. 

This week, Simply put asks whether the market still views France as an AA- credit risk. Should this perception have shifted, we also consider the potential outcomes investors are anticipating and which sovereign spread thresholds represent key indicators of changing market sentiment.

Forward-looking markets

Market participants understand the fundamental principle that financial markets function as forward-looking mechanisms. Fixed income markets have long been regarded as among the most anticipatory in the global financial system. This implies that a direct comparison between current ratings and prevailing sovereign spreads would be methodologically unsound, as it would incorrectly attribute forward-looking price signals to past public information. While various aspects of Fama's Efficient Market Hypothesis have faced scholarly criticism over the past two decades, the tenet remains largely intact. 

Establishing meaningful correlations between spreads and ratings, therefore, requires a careful alignment of the timing of the data. Specifically, we need to determine the forward-looking horizon embedded within sovereign spreads – defined as the difference in yield between a sovereign issuer and the benchmark bond within the same currency area.

Figure 1 shows the relationship between index ratings and sovereign spreads across European markets from 2010 to 2025, using the measure known as the MacFadden R² coefficient. This analysis adjusts for different time horizons to see how the relationship changes. We can't use simple correlation here because credit ratings essentially move in discrete steps. Instead, we use the ordered Probit regression to connect them to the real-valued numbers that are sovereign spreads. 

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The data visualisation reveals that the connection between ratings and spreads is weak when looking at the same point in time. The statistical relationship strengthens considerably as the forward-looking horizon extends, reaching its maximum at the 24-month mark, while having reached a high enough level after one year.

Verification of this temporal relationship is essential to accurately evaluate whether current market pricing continues to align with France's AA- credit assessment.

FIG 1. Explanatory power of ratings over market spreads¹  (McFadden R²)

What is France really worth?

Figure 2 illustrates the estimated spreads for sovereign issuers in the eurozone over the 2010-2025 period, accounting for the forward-looking nature of markets. From AAA to A+, average spreads generally remain below 50 basis points (bps), representing a relatively modest premium. However, from A ratings downward, this premium increases, becoming particularly pronounced for BBB-rated issuers with spreads well above 100 bps. Here, the experiences of Greece and Cyprus provide key examples of downgrades within the eurozone. Although these crises are now in the past, they offer valuable benchmarks for levels to monitor.

France currently holds the equivalent of an AA- rating with Moody’s, which typically corresponds to an average spread of 20 bps. However, France's index level spreads are hovering around 40 bps – suggesting that the market views France as no longer truly fitting the AA category, but rather belonging in the A bucket – in line with S&P and Fitch's newly assessed ratings. Our estimates indicate that France is closer to an A+ rating, which, importantly, is not catastrophic news.

When translated into the closely watched 10-year spreads, this corresponds to approximately 80 bps. The key threshold to monitor for entry into a danger zone would be an additional 20 bps, meaning 60 bps for index level spreads and 100 bps for 10-year yields. Exceeding these levels would suggest markets anticipate France falling to the lower end of the A rating bucket. This development would become concerning, as the next downward step would be entry into the BBB category, accompanied by a 50-70-bps spread increase – representing a genuine danger zone.

FIG 2. Estimated European sovereign spreads per rating² (2-year lead)

BBB rating risks

Falling into the BBB bucket would be problematic for a country's creditworthiness, as the accompanying rise in spreads by 100 bps or more would clearly signal that markets had lost confidence in the nation's ability to service its debt. However, this is not the only disadvantage for countries descending to this rating category.

Figure 3 shows corporate spreads by rating using the same methodology used in Figures 1 and 2, comparing these values to sovereign spreads. A distinct pattern emerges: for ratings ranging from AAA to A, there exists a premium associated with being a sovereign issuer, evident in the difference between corporate and sovereign spreads throughout the period. This sovereign advantage amounts to approximately 50 bps. It stems from the fundamental principle that sovereign issuers have inherently stronger incentives to repay their debt – to maintain market access, governments need to be perceived as reliable borrowers.

However, this principle has its limitations, as the significant number of sovereign defaults over the past 200 years demonstrates. When markets begin pricing a sovereign issuer in the BBB category, this sovereign premium effectively disappears, and the sovereign issuer is treated on equal terms with corporate entities. This relationship is clearly visible in the chart and explains why a further 100-bps widening in France-Germany spreads would be a genuine concern. Such a movement would correspond to an approximate 180-bps spread with Germany, a critical threshold to monitor.

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FIG 3. Estimated European sovereign and corporate spreads per rating³

The investment implications for multi asset investors 

Our All Roads strategies consistently emphasise the diversification of exposures, both within asset classes and risk premia, and across them. The current level of political risk in France (or in the US) calls for asset diversification and careful comparison between trends and risks. These risk factors have so far exerted only a short-lived effect on financial markets, implying that it is essential to stay invested in those moments in order not to lag markets, while balancing risks and opportunities.

Simply put, France is currently treated as an A+ issuer by markets – any further deterioration would place the country in a difficult spot.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• The main contributor to our growth nowcaster this week was the US, which declined, while the eurozone and China remained flat. The deterioration stems from weaker production expectations data
• Deterioration in costs data in the eurozone contributed to a decline in the global signal, bringing it closer to the low and rising regime
• There were no changes in our monetary policy signals; the global indicator remains situated in the low and rising zone.

World growth nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).