Tough bank regulations are forcing Swedish companies to seek alternative financing sources, prompting a recent surge in corporate bond issuance that's expected to continue this year.

This surge in bond issuance is taking advantage of interest among investors looking for more lucrative yields than what's on offer in the sovereign debt market.

Total bond issuance volumes in Sweden rose 15% to 363 billion Swedish kronor ($53.5 billion) in 2011 from 2010, according to Danske Bank. In January, the total volume soared 71% to SEK42 billion compared with the same month last year.

"There's been a high level of activity since the beginning of the year," said Louis Landeman, head of credit analysis at Danske Bank in Sweden, adding that companies here benefit from Sweden's sound state finances and can often find lower borrowing rates than their European peers.

As in Europe, Swedish corporate bonds have traditionally made up a relatively small amount of corporate debt - about 20% versus 80% bank loans. In the U.S., bonds make up about 50% of corporate debt.

However, this is about to change as international financial regulators, in the wake of the recent financial crisis, have been rolling out tough new rules for banks' capitalization and liquidity in order to limit risks in the financial system.

The Basel III regulatory framework, which will be implemented over the next few years, calls for core Tier 1 capital ratios -- a measure of financial strength -- of at least 7%, as well as stricter rules for liquidity and funding. Because Sweden has an unusually large banking sector compared to GDP, lawmakers here have launched even tougher requirements, for core Tier 1 capital of at least 12% of risk-weighted assets by 2015, in order to reduce the economy's vulnerability.

As banks become increasingly picky about who they lend to and start to charge higher interest, an increasing number of companies are finding it cheaper to borrow elsewhere.

"There is a greater interest among Swedish companies to diversify their funding. Tele2 (TEL2-B.SK), Intrum Justitia (IJ.SK) and Northland Resources (NAU.T) are just a few of the companies that have turned to the corporate bond market for the first time this year," said Stefan Ericson, fixed income portfolio manager at Carnegie Funds.

Swedish engineer Sandvik AB (SAND.SK) Feb. 21 announced the issue of a SEK1.1 billion corporate bond, in a move to broaden its investor base for borrowing.

"We expected to issue SEK300 million but the great interest shown forced us to close the offer after only 3 days. There seems to be a great interest to invest in stable companies with strong financials," Sandvik treasurer Anders Orbom said in a statement.

Real estate companies are, according to Erik Oberg at Swedbank Credit Research, among the first to experience a slump in bank funding, "mainly explained by a low level of ancillary business needed to justify decent returns on loans."

In December, Swedish real estate companies Fabege AB (FABG.SK), Brinova Fastigheter AB (BRIN-B.SK), Peab AB (PEAB-B.SK) and Wihlborgs Fastigheter AB (WIHL.SK) formed a joint finance company with the specific intention to find alternative funding. The joint venture has so far issued a three-year SEK650 million bond, secured by mortgages in the owner companies' real estate.

Another Swedish property company that recently turned to the debt market is Klovern AB (KLOV.SK), which last month issued a three-year unsecured SEK599 million bond in the Swedish market. The bond has a variable interest of 4% over three-month Stockholm interbank offered rate and matures in 2015.

This was followed by another three-year unsecured bond of SEK320 million at the same interest.

"Interest in other forms of financing has increased as liquidity in the banking system has diminished," said Klovern Chief Executive Rutger Arnhult in a statement. "We are very satisfied with the interest in Klovern's bond and can definitely think of using this possibility again."

High yield bonds or junk bonds, issued by speculative grade companies, are also becoming more common in the Swedish debt market. The high yield bonds, which give investors a higher return on their money due to the higher risk involved, accounted for about 7% of corporate debt in Sweden in 2011, compared with 25% in the rest of Europe, according to Danske Bank.

"We see a potential for both the high yield and real estate sectors to continue to grow in 2012," said Landeman.

For investors, the extra money to be made from corporate bonds compared with what they could earn on sovereign bonds, the so called credit spread, is currently at a historically high level. The yield on a Swedish 10-year sovereign bond currently trades at around 1.82% compared with roughly a 5% to 8% average return on corporate bonds, according to Carnegie Funds.

Ericson said Carnegie Funds has seen a 40% increase in their corporate bond portfolios in the last year.

"We've had an influx of money into our corporate bond portfolios and this has increased our purchasing power," said Ericson noting that other Swedish pension funds are currently evaluating increasing their exposure to corporate bonds too.

The buyers of Swedish bonds are mainly institutional investors such as pension and bank funds. Private investors only make up a very small part of the market. A majority of the bonds issued in Swedish kronor are traded over the counter at the regions larger banks and only about 40% are listed and traded at the NasdaqOMX Stockholm exchange.

-By Christina Zander, Dow Jones Newswires +46-8-5451-3104; christina.zander@dowjones.com

(Gustav Sandstrom and Katarina Gustafsson contributed to this report)