By John Geddie
LONDON (Reuters) – Investors across the world who track bond indexes may be stranded with loss-making French debt if National Front leader Marine Le Pen wins the presidential election and, as she wants, takes the country out of the euro zone.
Index providers – whose clients have trillions of dollars in funds – have told Reuters that denominating bonds in a different currency would not necessarily mean they would be withdrawn from the indexes, even if ratings firms said the country was in default.
That would open the door to losses in the new currency.
Presidential hopeful Le Pen – an anti-euro, far-rightist with an unlikely but outside chance of snatching victory in May’s election run-off – has said she would take France out of the euro and denominate its national debt in a new currency.
Such a redenomination, some analysts estimate, could mean an effective currency loss of up to 30 percent on French debt, among the highest-rated and most widely held in the euro zone.
Faced with such losses, many active investors would probably have sold out long before Le Pen put her plan into action.
But passive funds, or index trackers, however, could be left wearing those losses if there were no change to the fixed income indexes they follow.
While some ratings firms have indicated redenomination would result in a default rating, lawyers have argued that legally there would be no default for the vast majority of French government bonds, which are governed by local legislation.
Bank of America Merrill Lynch – one of the biggest bond index providers – says it would remove securities deemed in default based on their “individual legal terms” but not because a major rating agency declared an issuer to be in default.
An analyst at another provider, who wished to remain anonymous, also said his firm does not rely on ratings for its main flagship indices and that bond liquidity – the ability to buy and sell smoothly – was the main qualifying criterion.
He added that withdrawal could also be detrimental to the functioning of financial markets and that this would also be a factor in their decision whether to remove the bonds or not.
“If there is an extraordinary event and indices across the board have to remove bonds then we have a one-way market all happening at once, so that is not necessarily beneficial for the end investor,” the analyst said.
While many active funds benchmarked to the indexes could still decide to sell their French debt, what they call going “underweight” or “short”, some passive investors such as exchange-traded funds (ETFs) have to hold bonds in the index.
Of the $6.8 trillion in fixed income-specific bond funds globally, nearly $1.3 trillion passively track indexes. Vanguard, BlackRock and Fidelity managed the biggest funds, data from research firm Morningstar shows.
Passive funds tend to try to replicate an index unless the bonds are not readily available in the market. Finding a substitute for French government debt – which in some cases makes up more than 5 percent of an index – would be difficult.
Even providers that have rating limits on their indexes said any withdrawal of French debt may not happen immediately in case ratings firms decided to quickly issue a post-default rating.
In an interview with Reuters, Standard & Poor’s chief sovereign analyst, Moritz Kraemer, hinted that any French default due to redenomination might be “rather short”.
“There is no resolution required like in a restructuring of debt like in Greece or Argentina, so this default episode might be rather short,” Kraemer said.
“There is nothing to wait for. They are going to continue paying in francs, so there is no value to the capital markets in keeping the country in default for months on end if the situation would just continue.”
A senior director at a third provider also said it would keep defaulted bonds in its index if the rating was only going to be temporary. Providers tend to rebalance their indexes at the end of every month.
(Editing by Jeremy Gaunt)