A euro zone country missing its fiscal targets, on the brink of recession, with an unpopular president and a population notorious for its resistance to reform, might seem the perfect combination to scare away investors.

But France benefits from being in many ways a halfway house between other, more robust, core euro zone economies and crisis-hit periphery states whose debt offers higher returns but with more risk.

Its long-held position as one of the world's richest economies, and place beside Germany at the heart of Europe, have also helped its yields fall this year from already low levels as cash from global central banks washes through markets.

"French bonds are in a sweet spot," said Franck Dixmier, Allianz Global Investors' head of European bond investments.

"This decorrelation between French bond yields and France's economic fundamentals could go on as long as investor sentiment towards the country remains relatively positive.

"But France is walking a tightrope," he warned, pointing at risks including a further flare-up of the debt crisis or the loss of France's sole remaining triple-A credit rating.

A key test will be France's revised fiscal policy for the next four years, which President Francois Hollande's cabinet will adopt on Wednesday. It must be solid enough to convince euro zone partners to give the country a one-year reprieve to bring its deficit below the EU's 3 percent of GDP ceiling.

"I think Hollande will be able to create more goodwill in Brussels if he pushes reforms on the structural front," said Willem Verhagen, senior economist at ING investment management.

"Spreads (within the euro zone) have very little to do with what we normally think of as fundamentals ... All is conditional on a country being a 'good citizen'."

RESILIENT TO BAD NEWS

Poll ratings for Hollande's Socialist government are at record lows after a string of bad economic releases. It has acknowledged it will miss its deficit target this year and slashed growth forecasts, while most analysts see a recession.

Unemployment is near 15-year highs just as it prepares a sensitive pension reform and overhauls labour laws, and it must find spending cuts of more than 60 billion euros by the end of 2017 to come anywhere near a promise to balance its budget.

To make things worse, the man in charge of organising the belt-tightening, ex-Budget Minister Jerome Cahuzac, quit last month after admitting he had a secret foreign bank account, making the already unpopular reform drive look even shakier.

"In France, in some respects yields are immune to fundamentals at the moment because there's abundance of liquidity and there are expectations that there will be even more of that," said Robert Talbut, chief investment officer at Royal London Asset Management.

"It's very difficult to predict when this will change because economic data doesn't seem to matter, political turmoil (elsewhere in Europe) doesn't seem to matter, people just expect more liquidity searching around for those yields in the future."

Dixmier at Allianz also noted the advantages of France's deep and liquid bond market, which makes it easy to buy or sell, and its appeal as a safe credit offering higher yields on its bonds than the United States, Germany or Japan.

Since the beginning of the year, France has issued bonds at an average rate of 1.42 percent, its debt management authority says, nearly half a percentage point less than at end-2012 and well below the previous record low of 2.53 percent in 2010.

Its benchmark 10-year bond currently trades at record lows of just over 1.8 percent. That is nearly two full percentage points lower than two years ago and far less than 10-year bonds of Spain and Italy, which both yield well over 4 percent despite sharp falls as the euro zone crisis has eased.

Talbut, who manages assets worth around 50 billion sterling, said he was underweight on France because he thought yields there were too low given the fundamentals.

Underscoring the resilience of France's bonds to bad economic news, it sold 10-year paper at a record low yield of 1.94 percent in early April. On the same day, Markit's much-watched purchasing managers' index showed the country's dominant service sector shrank at its fastest rate in four years, dragging down the reading for the whole euro zone.

RISKS REASSESSED

Low yields have helped make servicing the debt of the zone's second largest economy less onerous despite its economic woes and the loss of two of its three top-grade ratings. Last year, France cut its interest bill by 0.7 percent even as its debt grew from 85.8 percent of GDP in 2011 to 90.2 percent, to reach over 1,833 billion euros.

Investors have kept buying French debt despite its missing its budget targets for years, but some warn the bleak growth outlook in France and its euro zone trading partners will eventually catch up with the country and push up its yields.

"The risk of a recession in France and the Netherlands and the weak growth in Germany have not yet been entirely priced in by the market," said Morgan Stanley's Elaine Lin, who argues that the markets were on the brink of reassessing French debt before Japan's policy shift caught them off guard.

The Bank of Japan announced unprecedented stimulus plans earlier this month, while other global central banks also continue to print money to help foster economic growth.

Even before that, buyers in Asia and the Middle East were responsible for half of net purchases of French government bonds in 2012, with total non-resident holders of French debt reaching 62 percent.

On the other hand, Lin said, if the outlook in the euro zone worsens it might encourage the European Central Bank to cut rates, which could again drag German yields lower and make French debt look more attractive.

The weight of central bank cash should anyway mean any rebound in French yields is gradual, said Rachid Medjaoui, a senior official at France's La Banque Postale Asset Management.

"In many countries, central banks want to keep real interest rates negative," he said, pointing to liquidity injections by major central banks including Japan and the United States.

(Additional reporting by Raoul Sachs and Marius Zaharia; Writing by Ingrid Melander; Editing by Catherine Evans)

By Ingrid Melander and Blaise Robinson