Analysis-Markets eye new wave of joint European bonds in rush to boost defence

By Yoruk Bahceli

LONDON (Reuters) - Big investors are sensing that a fresh joint European borrowing effort is becoming more likely as the region scrambles to ramp up defence spending.

The modest reaction across bond markets, typically unnerved by higher spending, as defence talks gathered pace this month suggests investors view increased borrowing as manageable so far.

They say it also suggests markets expect some form of joint European funding again, five years after the European Union launched an 800 billion euro ($840 billion) pandemic recovery fund.

Late last year investors saw joint borrowing from the EU itself as less likely. But the need for action has re-emerged as U.S.-Russia talks to end the Ukraine war sideline Europe and pile pressure on a bloc already urged to up spending by U.S. President Donald Trump.

The EU believes 500 billion euros of investments are needed over the next decade. But raising defence spending to 3% of output would require nearly 200 billion euros per year more.

Germany's 10-year yield rose less than 10 basis points after Trump started talks with Russia but has since reversed that move.

The additional yields Italy and Spain, which spend much less than 2% of their output on defence, pay over Germany's debt have barely moved.

"The knee jerk (reaction) is that governments start spending some extra, but it won't be huge amounts," said David Zahn, Franklin Templeton's head of European fixed income.

"The bigger amounts will have to come from some type of centralized funding, because most budgets in Europe are relatively stretched," he added, particularly in Italy and France.

He has sold EU bonds expecting more joint issuance, while Vanguard is sticking to a bet on Italian and Spanish bonds.

"If they (policymakers) are serious about it, then there comes a point where we're going to have to think about issuance of joint defence bonds," said AXA Investment Managers fund manager Nicolas Trindade.

"That's where you have the most capacity."

Some analysts reckon even Germany, which will face a huge spending shortfall unless it agrees a new defence fund, may benefit from joint borrowing it has so far opposed.

Germany is seeking potentially hundreds of billions of euros for defence spending before a new parliament potentially blocks the move.

MATTER OF TIME

Whether it's a new funding vehicle that includes Britain or more EU bonds -- the most welcome outcome for investors, making the bloc a more permanent borrower -- a joint solution is expected, albeit not immediately.

First, the bloc is looking at temporarily exempting defence spending from its budget deficit rules. It could then shift roughly 90 billion euros of unused loans to defence from its recovery fund.

So further joint borrowing may not come until 2027, said Carmignac economist Apolline Menut, adding German efforts to find a fast national solution may also reduce the urgency.

The question is how much extra borrowing investors will tolerate when they're already buying record amounts of euro zone debt and are uneasy about high deficits in big economies.

Investors say it's hard to judge without knowing how much money is needed and over what time horizon.

Britain aims to raise spending gradually over several years.

One clear reaction has been in Germany, where longer-term borrowing costs exceeded shorter-term ones by the most since 2022 this month, suggesting more bond sales are anticipated.

Asset managers including AXA, Allianz Global Investors and Northern Trust say higher defence spending supports steeper yield curves.

Yet Germany's 10-year yield, around 2.5%, is nearly 2 percentage points lower than in the U.S. Even Italy's is 80 basis points less.

"Yields are quite reasonable in Europe at the moment. I don't see it as a major constraint," said Franklin Templeton's Zahn.

German yields have remained largely unchanged since 2023, when the European Central Bank halted rate hikes, Citi notes. The amount of debt investors need to buy has only increased since then.

It still believes yields could eventually fall below 2% as tighter financing conditions prompt more rate cuts.

Bond investors also want to see if defence spending lifts euro zone growth, making debt levels more sustainable.

Goldman Sachs senior European economist Filippo Taddei reckons every euro of extra defence spending would boost output by just 40 cents initially.

The impact could be much bigger if it boosts industry and raises productivity.

"It's obviously unclear ... but the market is pricing a decent probability that that could happen," Taddei said.

($1 = 0.9522 euros)

(Reporting by Yoruk Bahceli; Editing by Dhara Ranasinghe and Hugh Lawson)