By James Mackintosh

France isn't Greece. But as investors worry about the impending presidential election, French bonds have shifted from trading like safe-haven German bunds to be treated more like troubled Italian debt.

The reassessment of France -- from part of the eurozone's financial core toward its periphery -- shows the heightened concern about far-right National Front leader Marine Le Pen winning the presidency.

The effects on trading were visible even as fears about France receded this week. The daily move in French yields was much closer to that of Italy than of Germany, both as yields rose and fell. This shift began shortly before the U.S. elections in November, amid talk of a populist surge.

Ms. Le Pen will almost certainly lose, but that doesn't mean French bonds are wildly mispriced or traders are mistaken to treat France more like Italy than Germany.

Investors are trying to price two things: The risk that France leaves the euro, and the loss that would result from being repaid in devalued francs instead of euros. Many, particularly outside France, think both risks have risen. Ms. Le Pen's chances are slight -- I'll come this later -- but a "Frexit" from the euro would be so catastrophic for bondholders that even small increases in the chance she will occupy the president's Élysée Palace have a big impact on bonds.

The point of introducing a new franc, as Ms. Le Pen has set out, would be to take back the central bank and print money to finance government spending. A plunge in the franc's value is certain, but France can't be considered in isolation. If France leaves the euro, it is very hard to see how Spain or Italy could remain.

The euro could survive only as a kind of deutsche mark-plus, with hard-currency northern European countries sticking with Germany. This would amount to a catastrophe not only for holders of French bonds but for investors in Italy and Spain too. When this is the focus, French bonds trade more like the periphery.

To see how French bonds trade, look at how much of their move is explained by the direction of Italian and German bonds. From the July 2012 promise by European Central Bank chief Mario Draghi to do "whatever it takes" to hold the euro together up to late October last year, French bonds moved much more closely with German bunds and had little link to Italian debt. Since fears of a global populist backlash began to grow in October, the situation has reversed, with French and Italian debt closely linked and the connection to German bonds weaker.

Bond market treatment ofFrance matches how the nation is regarded by economists. "France now is somewhere between proper core and periphery," says Antonio Garcia Pascual, Europe chief economist at Barclays. "None of these countries look in great shape, not France or Italy or Spain."

Something similar happened at the height of the last euro crisis, when those betting on a currency breakup began to lump France in with the periphery.

Yet, the absolute level of risk priced in to French bonds remains astonishingly low, with the 10-year yield on Thursday back below 1% and Italian bonds yielding below 2.2%. It is only relative to Germany that the fear shows up, with 10-year bunds yielding 0.31%.

A measure created by Roberto De Santis, an ECB economist, based on credit default swaps, shows a rise in the past few months in the risk of eurozone bonds being repaid in a different currency in Italy, Spain and France. However, the rise was from a very low level --in the case of both France and Spain the lowest since late 2011.

But even a slightly higher chance of a bond apocalypse is enough to drive up the extra yield investors demand to hold French bonds.

Another explanation for the low French yield is the ECB's buying of EUR60 billion of eurozone bonds each month. As the manager of one large European hedge fund put it, "It's shocking how wide [the France-Germany spread] is given the ECB's buying all the bonds."

In terms of Ms. Le Pen's chances, at best they've risen to negligible from nonexistent. Laurence Boone, Axa chief economist and a former adviser to French President François Hollande, points out that polls have been a good guide to Ms. Le Pen's support in the past. Even if the populist surge like that seen in the U.S. is repeated in France, polling errors would need to be far bigger to give her a hope in the French system. The latest polls give her only about a third of the vote if a second round pits her against current front-runner Emmanuel Macron , a centrist former economy minister.

Investors who think the world is being turned upside down by populists will still see value in betting that the French-German bond spread will widen far more on a Le Pen win. For everyone else, don't worry about boredom. There is an early test of European populist power in March with the Dutch elections, then the excitement of the German election later this year, and the wild card of a possible Italian election, complete with anti-euro populists who have a shot at government.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

February 09, 2017 14:29 ET (19:29 GMT)

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