France’s debt crisis could spread. Which bonds should investors watch?

France’s exit from its simmering debt crisis is nowhere in sight, and investors are already assessing the risk that it could spread to other eurozone countries. Their focus is not just France but also Italy, Spain, and Greece. How likely is a new crisis in Europe?

The yield on France’s 10-year government bond has surged to 4.97%, its highest in almost a quarter of a century. The budget deficit is expected to reach 5.4% of GDP in 2026, while government debt is projected at 119.3% of GDP, the investment bank Macquarie estimates. Mass protests by public-sector workers and high school students have been underway in the country for two weeks. The latter are unhappy with overcrowded classrooms, a shortage of teachers, and the poor condition of schools.

Even far-right leader Marine Le Pen has promised to slash government spending if she comes to power as president in 2027. She has also called on the European Central Bank to “intervene” in the government bond market and “ease the burden of interest rates” to give eurozone countries more room to invest in defense, technology, and the green transition.

In reality, no French politician is willing to admit that the country's public finances are out of control, Bloomberg Opinion columnist Lionel Laurent writes. The far left wants to cancel the country’s debt and tax the rich to lessen the pain on ordinary citizens, but that is fantasy land, Laurent says. On the other extreme is Le Pen, who has proposed enshrining a cap on government spending in the constitution. Yet that is “a fig leaf to cover all of her own giveaways.”

“The political center is inaudible right now,” Laurent believes. “Meanwhile, French schools are burning, the most extreme reflection yet of what happens when you spend decades keeping pensioners in clover and don’t invest in the future.”

Which countries may be at risk? Elections are approaching in France, Italy, and Spain, Commerzbank analysts flag in an October note. France’s presidential election and Italy’s parliamentary election will take place in the second quarter of 2027. Spain’s prime minister called an early election on Monday amid housing and immigration crises, which increased the uncertainty in markets.

Many analysts have pointed to the widening spread between French and German government bond yields as a market indicator of declining confidence in France’s financial stability. But similar spreads on Italian and Spanish government bonds are widening too, the Commerzbank note points out.

Although the move is much less pronounced than for French bonds, the market appears to be pricing in the possibility of a more serious crisis, the analysts wrote. This is especially true given the turmoil in global bond markets, where, for example, the yield on 10-year U.S. Treasuries has risen to its highest level since 2002.

The spread on French sovereigns over German Bunds jumped to 1.4 percentage points this week, up from less than 0.9 percentage points in early and mid-September. The spread on Italian and Greek sovereigns over Bunds had already exceeded 1.1 percentage points in early October, while that on Spanish government bonds was above 0.6 percentage points, Macquarie analysts noted.

This means investors are assigning a higher probability to rising instability in these countries. The euro hit a 17-month low of $1.116, before bouncing back slightly to trade at $1.12 on Friday.

“The euro has continued to weaken... driven by intensifying fears over the destabilizing financial conditions in the euro zone triggered by the sharp selloff in French government bonds,” said Lee Hardman, senior currency analyst at MUFG.

This was compounded by concerns about “the re-emergence of fragmentation risks in the euro zone” like those seen during the debt crisis in the early 2010s, which could make it harder for the ECB to implement monetary policy. “The politics of Europe are really starting to deteriorate,” added Eric Robertsen, chief strategist at Standard Chartered.

France, now at the center of the risk, “does not appear to have either the will or the ability to get its fiscal house in order,” he argues.

The situation in France is serious, but not everyone in the market agrees that it resembles the euro zone debt crisis of the first half of the 2010s.

“We are cautious on the euro’s performance but comparisons to 2012 are well off the mark,” said Geoffrey Yu, a senior strategist at BNY.

The spread on Greek bonds, which were at the center of that crisis, peaked at 30 percentage points, Macquarie analysts noted. The spreads on Italian and Spanish bonds, which were also hit, exceeded 5 percentage points and 6 percentage points, respectively. Even France’s spread – when its fiscal position was much better than it is today – approached 2 percentage points.

“The big question is whether this is the start of a new euro sovereign crisis or whether markets have already overshot… My bias is towards the latter,” the FT quoted Jim Reid, global head of macro research at Deutsche Bank, as saying.

The ECB has tools to counter unwarranted and disorderly market moves if they begin to threaten the effective transmission of monetary policy. ECB President Christine Lagarde told eurozone finance ministers this in response to a question about rising yields, Bloomberg reported, citing people at the closed-door meeting. But the question of which countries’ markets the central bank would support remains open.

Regulators have also begun conducting additional checks on banks’ resilience to risks related to their government bond portfolios, European Banking Authority Chair François-Louis Michaud told Bloomberg.

Managers at several large investment funds told the FT that they had begun buying bonds caught up in the selloff. For now, they are targeting papers that have been collateral damage rather than French government bonds.

Alex Everett, a fund manager at Aberdeen Investments, has bet on a recovery in Italian bonds. “Despite recent volatility, the European government bond market today benefits from materially stronger institutional backing and market confidence,” he said.

Jason Borbora-Sheen, a portfolio manager at Ninety One, sees little reason to increase the fund’s holdings of French sovereigns ahead of the 2027 presidential election. Instead, he is adding to other assets hit by the selloff that are fundamentally “very low” in French sovereign risk exposure.

Some investors are buying French corporate bonds, particularly those with large international businesses. About 38% of French investment-grade corporates, with a face value of EUR215 billion, now trade at yields below those on French government debt. At the start of the year, the total was EUR12 billion, Bloomberg calculated. In other words, the market now considers companies such as L’Oréal and TotalEnergies safer borrowers than the French government.

Although government debt is traditionally considered the safest, “France’s sovereign story and its corporate credit story have become increasingly disconnected,” said Elisa Belgacem, senior credit strategist at Generali Investments.

For Edward Farley, head of European investment-grade corporate bonds at PGIM, the key factor is where companies earn their money. For L’Oréal and LVMH, for example, “other than the fact that they’re domiciled in France, that’s about as material as it gets,” Farley told Bloomberg.