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Jan 06, 2012 12:01 PM IST | Source: Reuters

French debt sale solid but euro stress remains

France drew solid demand at its first debt auction of 2012 with yields rising only slightly despite fears for its AAA rating, but that was not enough to prevent most European debt markets weakening as investors fretted about the euro zone's periphery.

France drew solid demand at its first debt auction of 2012 with yields rising only slightly despite fears for its AAA rating, but that was not enough to prevent most European debt markets weakening as investors fretted about the euro zone's periphery.

Debt sales next week by more fragile euro zone economies Italy and Spain may provide a stronger test of investor appetite for the battered region.

Investors had eyed the sale of 10- and 30-year OAT bonds for signs that France's slowing economy, looming presidential election and weakening grip on its AAA rating was undermining appetite for its debt, threatening to drag the euro zone's second-largest economy into the vortex of the bloc's crisis.

The auction was nearly twice oversubscribed, however, with France selling 7.96 billion euros of bonds, at the top of its projected range, with the yields on benchmark 10- and 30-year bonds rising only slightly.

The yield on the benchmark October 2021 bond inched up to 3.29%, above the 3.18% when it was last auctioned on December 1, but in line with yields in the secondary market of just over 3.3%.

"Overall it's a pretty solid auction," Michael Leister, strategist at DZ Bank in Frankfurt. "It should be enough to dispel concerns with regards to France's funding capacity for the time being."

However, following the sale, the spread of French 10-year bonds over benchmark German Bunds widened, in line with faltering peripheral bonds, as the market's focus shifted to Italy and Spain.

The euro slipped to a new 15-month low against the dollar, helped along by positive US data, and European stocks slid, though Bunds rose as investors sought a safe haven.

The Italy and Spain sales next week are seen as the year's first big tests of fragile euro zone countries' ability to borrow at affordable levels. Italy, with 10-year bond yields above the 7% level widely seen as unsustainable, must pay out 100 billion euros in bond coupons and redemptions in the first four months of 2012 alone.

France's 10-year bond spread over Geman equivalents stretched by around 7 basis points to 149 basis points -- as Bunds rose -- but remained well below its euro-era high of more than 200 basis points reached in November.

Italian 10-year government bond yields were 10 basis points higher at 7.05%, with the Spanish equivalent up 8 basis points at 5.57% after rising around 35 basis points this week despite the European Central Bank buying bonds in the secondary market.

"The outlook for French bonds hinges critically on policymakers' ability to shore up confidence in euro zone sovereign debt markets, in particular Italy," said Nicholas Spiro of Spiro Sovereign Strategy. "Perceptions of French risk have become inextricably linked with perceptions of the eurozone."

France's AAA hanging by a thread

Investors have been spooked by a series of negative announcements from euro zone stragglers, including Spain's admission that the public deficit for 2011 may be higher than the 8% of GDP forecast by the new government.

Greek Prime Minister Lucas Papademos' call for citizens to accept painful reforms if they wish to avoid a default on debt payments due in March and remain in the euro has also unsettled some, traders said.

"Given the clear risk of an imminent ratcheting up of market tensions as Italy's February-April redemption hump looms closer, today's sales should be seen as a successful battle rather than in any way determining the outcome of the war," said Richard McGuire, senior fixed income strategist at Rabobank in London.

EU leaders have yet to agree on the exact details of a broad plan agreed in December to tighten fiscal governance in the euro zone, amid doubts over the bloc's ability to clinch a comprehensive deal to stem the crisis.

Citing continuing disagreements among policy makers, Standard and Poor's last month placed the credit ratings of 15 euro zone countries under review, singling out France as the only AAA country facing a possible two-notch downgrade.

itch, which also placed France on negative outlook, said last month a comprehensive solution to the crisis appeared "beyond reach".

A French downgrade would push up the cost of borrowing for the euro zone's EFSF rescue fund, but might not have a large impact on France's own borrowing costs, as it has been widely discounted by investors. It could, however, unsettle the balance of power in the Franco-German alliance driving the euro zone's crisis response.

The solid French sale came after Germany successfully sold 4.06 billion euros of 10-year bonds at its first auction of 2012 on Thursday, dispelling contagion fears sparked by a November auction which drew bids worth less than the 6 billion euros on offer.

France plans to issue up to 178 billion euros in medium- and long-term government debt, net of buybacks, this year, down only slightly from 184 billion euros in 2011, despite the threat to its rating.

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