Japanese investors hold French bonds well above the levels implied by benchmark index weights, raising the risk of a fresh wave of selling that could deepen the slump in the French bond market.

As of July, Japanese investors' holdings of French bonds were estimated at 23 trillion yen ($145 billion), accounting for 6.6% of their total overseas bond holdings, according to calculations. Relative to the benchmark weight in the Bloomberg Global Aggregate Total Return Index, Japanese investors' overweight position in French bonds is the highest among all eurozone countries.

France is facing a bond market crisis. As the government fails to meet its fiscal deficit targets, policy remains deadlocked, and next year's presidential election could completely change the country's direction, investor confidence in French government bonds is deteriorating.

Through multiple rounds of political and market turmoil in the past, Japanese investors have steadfastly held French bonds, but this time the risk of further selling may be higher. The reason is that rising domestic yields in Japan are making Japanese government bonds more attractive, strengthening the incentive for investors to repatriate funds and potentially weakening a major source of support for European bonds.

Hideo Shimomura of Fivestar Asset Management is among the investors who have already bet on further declines in French government bonds. "This is just the beginning," Shimomura said of the French bond selloff. "If the European Central Bank stands by and does nothing, then based on the experience of the European debt crisis, French 10-year government bond yields could rise as high as 7%, which is concerning."

French 10-year government bond yields have risen to about 5%, the highest level since 2002. French government bonds have fallen 4.9% this year, the fourth-worst performance in the global bond market. Japanese investors' holdings of French bonds have decreased 2.5% from the end of last year.

Investors such as Shinji Kunibe of Sumitomo Mitsui DS Asset Management Co. have already taken action. Due to concerns about France's fiscal situation, funds under his global fixed income team have fully liquidated their French bond holdings. Market participants say other foreign investors may follow suit.

"If the market believes that Japanese investors are cutting their overweight positions because France is no longer a core allocation that can be held with confidence, then benchmark investors in the United States, Asia, and parts of Europe may also reassess their holdings," said Antonio Del Favero, head of rates strategy at Macro Hive.