BAE systems (LSE:BA.) The stock has made a lot of money for investors over the last few years. We’re talking about a 35% annualized total rate of return over five years, which is almost triple that FTSE100.

Unfortunately, the original catalyst for this outperformance was the horrific invasion of Ukraine in early 2022. This sparked a sudden shift in European defense spending priorities as nations realized that large-scale land wars in Europe were no longer a thing of the past.

Unfortunately, war will likely continue as long as humans exist. However, the level of geopolitical instability has increased dramatically in recent years, the most recent example being the war in Iran that began in behind schedule February.

Theoretically, the situation in Iran should cause BAE shares to rise. The war in Russia certainly contributed to this, as did the US military operation in Venezuela in early 2026.

However, FTSE 100 defense stocks have actually fallen slightly since the conflict began. And anyone who invested £7,500 in BAE 10 days ago would now have just £6,620 after an 11.7% correction.

Why are stocks falling?

Even after the recent decline, BAE shares are not economical, trading at 25 times this year’s projected earnings. So it is likely that investors withdrew some of their profits (today the dividend yield is just 1.7%).

Another key problem, however, are rising energy and fuel prices. This situation not only increases BAE’s costs of producing and transporting equipment such as tanks, combat vehicles and artillery, but also puts further pressure on cash-strapped governments.

Since the beginning of the war in Iran, the yield on public debt in European countries has increased dramatically. The yield on 10-year British bonds increased from 4.2% to over 5%.

In other words, the UK’s borrowing costs have reached their highest levels since the 2008 financial crisis. Where will the UK and Europe get the money to finance their ambitious defense spending targets?

This question worries the market.

I think BAE will be fine

On the other hand, air defense stocks are under pressure due to wars in Ukraine and Iran, while national security threats continue to grow around the world. So I don’t think rising bond yields will change the growth story here.

For example, will the Gulf states want to strengthen security after Iranian drone attacks across the region? My mighty suspicion is that yes. BAE is one of the most essential defense partners of cash-rich Gulf states such as Saudi Arabia, Qatar and the United Arab Emirates.

Meanwhile, on Wednesday (March 25), Türkiye signed a multi-billion contract in London for training and support for parts for the first batch of British-made fighter jets.

The defense giant ended 2025 with an order book of £83.6 billion, with products spanning land, sea, air, cyber and space. The company is also exceptionally well-managed under the leadership of CEO Charles Woodburn.

I still own BAE shares, which I first bought in 2022, and I think they will continue to do well over the long term. However, given the increased valuation, I do not intend to strengthen my position today.

If the pullback reaches 20-25% (about £18 per share) I will start to get really interested. But until that happens, I see better opportunities for the FTSE 100.