Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.

History books will remember this week as Sweden cleared its final obstacle to join NATO after Hungary's parliament approved the Nordic country's accession. The 2022 Russian invasion of Ukraine has put into motion a series of events that are bringing an end to 200 years of neutrality in Sweden.

Ever since the Russian invasion of Ukraine, western governments have increased military spending substantially, reaching a record €240 billion in Europe last year. Such a move is propelling defense stocks higher, and the Invesco Aerospace & Defense Portfolio (PPA:arcx) has risen by 37% since February  2022 until today, while the VanEck Defense UCITS ETF (DFEN:xetra) has increased by 43% since inception (April 2023).

Why consider bonds in the defense sector?

As geopolitical tensions are unlikely to decline in the foreseeable future, the defense sector will continue to attract investments, creating opportunities for stock and bond investors.

Diversifying one portfolio into the defense sector might prove valuable because:

1. It offers stability. The defense sector is known for its stability, even during economic downturns. Governments worldwide allocate a significant portion of their budgets to defense spending, which provides a steady stream of revenue for defense companies.

2. It is heavily exposed to technological advancements. The defense sector is often at the forefront of technological advancements. Defense companies invest heavily in research and development to develop cutting-edge technologies like cybersecurity, artificial intelligence, and advanced weaponry. Investing in the defense sector allows investors to participate in the growth potential of these innovative technologies.

3. It has the potential for long-term spread compression due to increasing global security needs. As countries modernize their defense capabilities and adapt to new threats, defense companies will likely benefit from sustained demand for their products and services.

4. Global security concerns are escalating. With geopolitical tensions in Ukraine and Israel, governments must continue investing in defense capabilities, making it a contemporary theme in one portfolio.

Defense corporate bonds: threats and opportunities.

At the bottom of this piece, you will find a list of defense investment-grade and high-yield corporate bonds available on the Saxo platform. Depending on the credit rating, maturity, and coupon of each bond, the risk-reward profile of an instrument will change. However, when considering what bond to pick, it is important to keep the following in mind:

1. High-yield defense bonds spread over US Treasuries are the tightest on record. High-yield defense bonds pay 154bps over their US Treasury benchmark. Yet, the picture changes dramatically when we compare high-yield defense bonds with the broad junk bond averages. Indeed, US dollar defense junk bonds pay -120bps below the US high-yield average, a level that we hadn't seen before the war in Ukraine started since the Global Financial Crisis (GFC). That means that while, on average, US dollar junk bonds pay a yield of 7.8%, defense HY bonds pay just 6.6% in yield. On the contrary, investment-grade defense bonds pay an average yield in line with the IG average, around 5.4%.