(Bloomberg) -- The possibility that Europe will tap its investment bank to fund defense spending is being met with skepticism from bond investors, who flag risks to the lender’s sustainability credentials and higher borrowing costs. 

Given the European Investment Bank’s focus on environmental and social projects, it would likely have to reach other investors outside the ESG industry for any military financing. To analysts and fund managers, the better option is for the European Union to raise the money directly through its joint-borrowing program. 

How to counter the threat of Russian aggression and the EIB’s role in defense spending is on the agenda as EU leaders meet on Thursday. Several countries, including France and Germany, have called for the EIB to reconsider policies that restrict it from supporting military projects. 

Yet using the EIB raises some challenges. For one, the institution bills itself as the EU’s climate bank and its strong ESG ratings, which help borrow more cheaply, could be jeopardized if lending criteria is loosened to include defense. Matt Cairns, head of credit strategy at Rabobank, said the ESG-focused clients he advises are usually barred from military-linked investment.

“The EIB is a green bond issuer. It’s a climate awareness bond issuer. It’s a social bond issuer. So exactly what type of investors are going to put their hands up to buy bonds which are now funding military equipment?” he said. “Anybody I speak to has their hands tied on that sort of thing.”

An EIB spokesperson said President Nadia Calvino will speak to member states in April on expanding “the scope and the volume of support” for European security. 

With no end in sight to the war in Ukraine, the EU is under pressure to deploy more cash to protect itself. The EIB can currently finance spending on cybersecurity and drones that have civilian and military uses, but an expansion into munitions and weapons would likely cause a review of its environmental, social and governance ratings. 

According to Morningstar Sustainalytics, the bank has some margin to expand defense funding without hurting its top ratings, but any big shift could lead to changes. The EIB has the fifth-strongest ESG rating out of nearly 16,000 entities covered by the firm. MSCI rates it AAA, the highest level.

“They may have to accept they are implicitly diluting the ESG credentials of the EIB,” said Brian Mangwiro, a portfolio manager at Barings. “I see the EU being the simplest, most direct, most plausible way of funding this. The EIB will be a more complicated path.”

The EIB has nearly €430 billion ($466 billion) of debt outstanding across different currencies, according to data compiled by Bloomberg. To support the defense industry, it may need to raise an additional €10 billion to €30 billion annually in the coming years, based on estimates from HSBC Holdings Plc.

For that, the bank may have to scrap its lending cap, currently set at 250% of its subscribed capital. But removing that cap could harm the triple-A rating, HSBC analyst Frank Will wrote in a client note. 

Investors also said any EIB defense bonds would likely come with a higher yield. Currently, its bonds due 2034 yield 2.9% versus about 3% for similar EU debt. But if they were slated for military purposes, the EIB may face 10 basis point premium over EU notes sold for the same purposes, according to Kaspar Hense, a senior portfolio manager at RBC BlueBay Asset Management.   

Analysts see the EU as a better route because its investor base is larger and less ESG-constrained. France’s president Emmanuel Macron is expected to push for joint issuance at the EU summit on Thursday, the Financial Times reported. 

That could also shift EU debt from being a tool that’s only deployed during a crisis to a more permanent system with government status, Hense said. Others said that if the yield is high enough, then the EIB or EU would have no trouble finding buyers. 

“Things on investors’ side may change over time if defense-related investment is considered essential,” said Jussi Hiljanen, head of European macro and fixed income research at SEB. “Without security and defense, there will be no ESG.”

--With assistance from Greg Ritchie and William Horobin.

(Adds context on Macron in third to last paragraph.)

©2024 Bloomberg L.P.