By Marius Zaharia
LONDON (Reuters) - France is gradually breaking away from core European debt markets in investors' minds and its bond yields risk converging with those of the region's most indebted states unless it can convince them its triple-A rating will remain intact.
France's economy is fundamentally more solid than those in the south of Europe, with a debt to output ratio below the euro zone average, and its debt markets are much more liquid.
But with Italy drawn ever deeper into the euro zone crisis, some investors say France will be the next victim of contagion.
Their main concern is the French banking sector's exposure to over 600 billion euros (511 billion pounds) of Italian, Spanish and Greek debt, by far the largest in the euro zone, according to data from the Bank for International Settlements.
"The contagion to core countries is already visible in France," said Gerard Moerman, head of interest rates at Aegon Asset Management, who manages 20 billion euros of the firm's 250 billion euros of assets across the globe.
"Lots of investors don't trust it anymore or want to get rid of the exposure ... We've seen some of our clients wanting to leave France."
Further complicating matters, some measures proposed as a possible solution to the crisis, such as guarantees of future fiscal transfers via a leveraged EFSF bailout fund, could see France's top-notch credit rating downgraded.
France's 10-year government bond yield spread over Germany has grown by more than a point over the past four months to euro-era highs around 140 basis points.
The move is strikingly similar to what happened in Spain in the months before it lost its triple-A rating in 2010.
ING is recommending investors bet on a narrowing of French/Belgian yield spreads on the view that France's rating will soon fall to Belgium's AA, while Rabobank recommends investors sell French debt and buy top-rated Dutch bonds.
French debt has lately behaved more like a risky asset than like safe-haven German or Dutch bonds.
On Wednesday, when a sell-off in the euro zone periphery sent Italian 10-year yields to an unsustainable 7 percent, French yields rose, while Finnish and Dutch yields fell.
The 30-day rolling correlation between French and German five-year yields has decreased to about 0.65 from a very strong 0.95 since July -- around the time the euro zone agreed to impose losses on private sector holdings of Greek debt.
The correlation with Belgian debt, on the other hand, has risen from minus 0.15 to 0.2, while the correlation with Italy has grown from -0.6 to -0.1 over the same period.
"It is not like buyers are waiting on the sidelines for more attractive levels and when equity markets rally and there is a 'risk on' environment they jump in the market again," said WestLB rate strategist Michael Leister.
"The dynamic is pretty similar to Italy -- there seems to be willing sellers but no willing buyers."
That is also shown by indicators of market volume. The gap between the yields quoted to buyers of French bonds and those quoted to sellers has risen to 30 bps, three times what it was in July. That compares with 5 bps for Germany, 15 for Finland, 50 for Italy and 280 bps for Greece.
Beyond its exposure to external risks, France is also seen as a reform laggard among triple-A rated countries.
At 5.7 percent of economic output, France's projected fiscal deficit for this year is wider than for any other euro zone country apart from Greece, Ireland and Spain. Its pension system and labour markets are also cited as problems.
If it pursues reforms in that direction, it can keep its safe-haven status, analysts and investors say.
"France is certainly not insolvent to make you get rid of all the debt, but markets are certainly pushing France to reform," Aegon's Moerman said. "At some point, if it keeps its triple-A status, it is a very attractive yield to buy into."
France announced a five-year plan to save 65 billion euros on Monday, though, and some economists say that showed it was still on the right path.
"(France) is undoubtedly the weakest triple-A state ... but it is still credible, while Italy isn't," said Russell Silberston, who manages about $31 billion as head of global rates at Investec AM. "They have time to make adjustments and we believe they will take those measures."
He said his fund may not roll over French debt once its holdings mature if the euro zone crisis does not abate.
"If a euro zone break-up is what we get to, then preservation of capital is more important and there will be only one market where you could do that -- Germany," Silberston said.
(Editing by Nigel Stephenson)