The Rise of European Defense Bonds: A New Asset Class for Risk-Adjusted Growth?

The European defense bond market is emerging as a compelling yet complex asset class for investors navigating a rearmament-driven continent. With defense spending surging to 1.9% of GDP in 2024 and projected to reach 3.5% by 2035 [1], the EU’s strategic pivot toward security has created fertile ground for defense-linked fixed income. However, the investment case hinges on balancing geopolitical urgency with fiscal prudence, as governments grapple with competing priorities like climate mitigation and social welfare.

Defense Spending: A Catalyst for Bond Issuance

The EU’s defense spending boom, driven by Russia’s invasion of Ukraine and NATO’s 2035 5% GDP target, has unlocked new fiscal flexibility. The European Commission’s Readiness 2030 package allows member states to allocate an additional 1.5% of GDP to defense, while initiatives like the €150 billion Security Action for Europe (SAFE) instrument enable joint procurement [2]. Germany’s €650 billion defense plan and Poland’s 4.7% GDP target exemplify the scale of commitment [3]. These efforts are not merely about military readiness but also about reshaping Europe’s industrial base, with 30% of 2024 defense budgets allocated to capital formation for equipment and R&D [4].

Structuring the Defense Bond Market

Euronext’s European Defence Bond Label has provided a framework for classifying bonds financing defense projects, such as missile systems and cyber infrastructure. These bonds, labeled as “European Defence Bonds (EDBs),” are broadly fixed-income instruments with proceeds tied to strategic objectives [5]. The European Commission’s planned €70 billion in EU-Bonds for 2025 underscores the institutional backing for this asset class [6]. However, the market remains nascent, with limited transparency on coupon rates and maturities. Investors must assess whether the EU’s strong credit rating can offset risks like fragmented procurement processes and reliance on U.S. suppliers (64% of EU military imports in 2024) [7].

Market Dynamics and Investor Appetite

The 2025 bond market has shown resilience despite rising yields. The 10-year German Bund yield climbed to 2.75% amid expanded fiscal commitments, while the ECB’s rate cuts have supported shorter-dated bonds [8]. Defense bonds, with their alignment to geopolitical stability, may attract institutional investors seeking yield in a low-growth environment. The EUR high-yield market, for instance, offers a 5.36% yield-to-worst as of June 2025, outperforming U.S. counterparts when hedged to euros [9]. Yet, the sector’s success depends on maintaining fiscal discipline. The EU’s projected €800 billion defense spending by 2029 could strain budgets, particularly if social and climate investments are deprioritized [10].

Risks and the Path Forward

While the investment case is robust, challenges persist. The EU’s fragmented defense industry and reliance on foreign suppliers highlight vulnerabilities [11]. Additionally, meeting NATO’s 5% GDP target would require an extra €613 billion annually from EU members, diverting funds from green and social programs [12]. Collective borrowing mechanisms like the proposed European Defence Mechanism (EDM) could mitigate these risks by pooling resources and reducing individual fiscal burdens [13].

For investors, the key lies in diversification. Defense bonds should complement, not replace, traditional fixed-income allocations. Their potential for risk-adjusted growth is highest in a scenario where geopolitical tensions persist and EU fiscal coordination strengthens. However, a sudden shift in monetary policy or a slowdown in defense spending could erode returns.

Conclusion

European defense bonds represent a novel asset class born from necessity and opportunity. As the EU navigates a dual mandate of security and sustainability, these instruments offer a bridge between strategic priorities and capital markets. Yet, their long-term viability will depend on the EU’s ability to balance defense modernization with fiscal responsibility—a test that will define the continent’s economic and political trajectory in the 2030s.

Source:
[1] EU defence in numbers - Consilium.europa.eu
[2] The economic impact of higher defence spending - European Commission
[3] Sharing the burden: How Poland and Germany are shifting European defence expenditure - NATO
[4] EU Member States' defence budgets - EP Think Tank
[5] European Defence Bonds – can capital markets fund Europe's security? - White & Case
[6] The European Commission to issue €70 billion in EU-Bonds - European Commission
[7] European defence spending soars, but climate and care are still unaffordable - New Economics Foundation
[8] What Militarizing Europe Means for its Bond Markets - SSGA
[9] Why now? The case for European high yield - Morgan Stanley
[10] Fiscal aspects of European defence spending - European Central Bank
[11] The economic impact of higher defence spending - European Commission
[12] European defence spending soars, but climate and care are still unaffordable - New Economics Foundation
[13] Spending more on defence without damaging social spending - LSE Europp Blog