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.