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Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.
Althea Spinozzi
Spécialiste Fixed Income
Résumé: Adding exposure to the defense sector might offer stability and long-term spread compression as global security concerns escalate. Yet, since Russia invaded Ukraine in 2022, defense bond spreads have tightened significantly, offering a modest or even, in the case of junk defense bond space, a negative pickup over peers. Compared to investment-grade corporate averages, defense bonds have higher leverage and lower interest coverage but pay a yield of 5.4%, in line with the IG average. On the other hand, junk defense bonds have slightly higher leverage but almost double the investment coverage of the broad junk bond space. Hence, they are paying a yield of 6.6%, roughly 120bps below the broad high-yield corporate bond average.
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%.
Bullish sentiment in junk defense bonds might be spurred by improving fundamentals. US high-yield defense bonds have a higher interest coverage compared to investment-grade defense bonds and a leverage in line with investment-grade peers (see chart below).
2. Maturities within the defense sector will pick up only in the second quarter of 2025. That means that this sector will be less exposed to refinancing risk. As central banks are preparing to begin cutting rates this year, companies might be able to refinance existing debt on better terms compared to today, putting less strain on their balance sheets.
3. Interest rate risk remains a threat. Corporate bond valuations include an interest rate spread and a corporate spread. While the corporate spread relates to the health of a specific company, interest rates relate to monetary policies. Therefore, if benchmark rates are rising, corporate bond positions might incur losses even if the balance sheet of a specific company is improving, causing corporate spreads to tighten. That's exactly what happened in the past couple of years: corporate bond spreads have collapsed, but the Federal Reserve's hiking cycle has put upward pressure on yields, causing losses across fixed income space. The good news is that the tightening cycle has peaked, according to central banks on both sides of the Atlantic. That should be broadly supportive of fixed-income securities.
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