Bond funds run by some of the world’s largest asset managers are avoiding forced sales of French debt by changing their investment rules.

A €1bn ($1.2bn) State Street Corp fund and a €289mn BlackRock Inc product recently stopped using indexes with strict double-A credit rating criteria as their benchmarks. That allows them to maintain their exposure to French debt even as ratings downgrades push the nation below that threshold, according to people familiar with the matter.

The proactive tweaks are already bearing fruit. S&P Global Ratings’ sudden downgrade on Friday cost Europe’s largest bond issuer its average double-A rating among the three major agencies. That will force other funds with ultra-strict investment criteria to divest their French holdings.

“The change to the underlying index in question was made in response to clear client demand,” a State Street Investment Management spokesperson said. A BlackRock spokesperson declined to comment.

While the majority of funds will still be able to invest in French debt, outflows from ratings-restrained investors who don’t adopt new methodologies are widely expected in the coming months. Foreign reserve managers could gradually reduce their holdings of French government debt by €70bn, according to a Bank of America Corp analysis.

Funds compelled to ditch their bonds would need to significantly overhaul their allocations at a time when others may also be selling. For example, one benchmark that only invests in European government issuers rated double-A or above will reduce its 40% position in French debt to zero when it rebalances later this month.

For portfolio managers tracking such indexes, that would incur sizeable transaction costs as well as a portfolio concentrated in a smaller number of issuers — an outcome not necessarily in the interests of clients.

Moody’s Ratings is next up to review France on Friday. It currently rates the nation at Aa3, its lowest double-A score, with a stable outlook. Fitch Ratings cut the nation’s creditworthiness from AA- to A+ in September.

The BlackRock ETF squeezed its changes in just in time to avoid the impact of the French downgrades. The move came after Belgium’s rating was lowered to A+ by Fitch in June, giving BlackRock a taste of forced sales.

The fund’s benchmark — provided by S&P Global’s index business — had previously stated that if any of the major agencies rates a bond as A+ or lower, “that bond is removed from the index at the next rebalancing.”

That’s stricter than other methodologies which use the average of different credit scores and meant the BlackRock fund had to sell down its position in Belgian long bonds.

France posed a bigger risk: the nation accounted for almost a third of the fund’s portfolio. In the weeks following Belgium’s removal, a solution was found.

On July 18, S&P’s index arm proposed lowering the benchmark’s minimum credit-rating requirements to BBB. It also created a list of eligible countries to ensure the index’s make-up was aligned with its previous iteration before Belgium’s ejection.

The proposal was adopted and came into force in time for the rebalancing at the end of September. Now, French bonds are set to remain in the index even if there are further downgrades in the coming months, while Belgian bonds are back in the fund.

In a letter to investors in the ETF, BlackRock said the methodology change would avoid “increased turnover of index constituents and reduced index diversification.”

At State Street, meanwhile, the so-called IUT Euro Core Treasury 10+ Year Bond Index Fund previously tracked the ICE BofA 10+ Year AAA-AA Euro Government Index. However, in June it changed to a “custom” index from Intercontinental Exchange Inc., according to fund documents.

Custom indexes are designed with specific rules and criteria set by clients, unlike one-size-fits-all public benchmarks. The State Street fund had a 39% allocation to France as of end-September.

Others in the market moved to exempt France from rating requirements even earlier.

Northern Trust Corp’s High Quality Euro Government Bond Index Fund tracks a Bloomberg Index Services Ltd (BISL) benchmark. Its latest methodology dated November 2024 exempts France from minimum rating requirements altogether, along with Austria, Finland, Germany and the Netherlands. Previously it had a double-A ratings floor.

A Northern Trust spokesperson declined to comment. BISL is a subsidiary of Bloomberg LP, the parent of Bloomberg News.

To be sure, even after the recent downgrades, France remains comfortably in investment-grade territory. That’s considered a key threshold when it comes to bond-fund criteria.

Forced sales from the minority of investors with double-A criteria would also be an opportunity for other funds to pick up the bonds at “bargain prices,” said Mara Dobrescu, senior principal for fixed-income strategy ratings at Morningstar.

The larger impact from further French downgrades could be to global investor sentiment.

Foreign investors have for years favoured France because its yields are higher than Germany, while offering greater credit quality and less of the volatility associated with the likes of Italian debt.

“France risks slipping behind its peers and losing its long-held sweet spot among euro-area issuers that has long attracted global investors,” said Jean Dalbard, a researcher at Bloomberg Economics. “The cost would be structurally higher yields.”