AI Debt Explosion Has Traders Searching for Cover: Credit Weekly
(Bloomberg) — As tech companies prepare to borrow hundreds of billions of dollars to ramp up investments in artificial intelligence, lenders and investors are increasingly trying to protect themselves against anything going wrong.
Banks and money managers are trading more derivatives that offer payouts if individual tech companies, known as hyperscalers, default on their debts. Demand for credit protection has more than doubled the cost of credit derivatives on Oracle Corp.’s bonds since September. Meanwhile, trading volume of credit default swaps tied to the company jumped to about $4.2 billion in the six weeks ended Nov. 7, according to Barclays Plc credit strategist Jigar Patel. This was down from $200 million in the same period last year.
“We are seeing renewed interest from clients in single-name CDS discussions, which has diminished in recent years,” said John Servidea, global co-head of investment-grade finance at JPMorgan Chase & Co. “Hyperscalers are highly rated, but they’ve really grown as borrowers and people have more exposure, so naturally there’s more customer dialogue around hedging.”
A representative for Oracle declined to comment.
Traders said trading activity was still small compared to the amount of debt expected to flood the market. But the growing demand for hedging is a sign of how technology companies seeking to reshape the world economy with artificial intelligence are beginning to dominate capital markets.
Investable companies could sell about $1.5 trillion in bonds in the coming years, according to JPMorgan strategists. A number of major AI-related bond sales have hit the market in recent weeks, including Meta Platforms Inc.’s sale of $30 billion in notes in late October, the biggest corporate issue of the year in the U.S., and Oracle’s offering of $18 billion in September.
Technology companies, utilities and other borrowers tied to AI now make up the largest portion of the investable market, according to a report from JPMorgan last month. They displaced the banks that had long held the largest share. Junk bonds and other major debt markets will also face a wave of borrowing as firms build thousands of data centers around the world.
Some of the biggest buyers of single-name credit default swaps on tech companies are now banks, which have seen their exposure to tech companies increase in recent months, traders said.
Another source of demand for derivatives is stock investors looking for a relatively cheap hedge against stock declines. The cost of buying protection against Oracle defaulting over the next five years as of Friday was about 1.03 percentage points, or about $103,000 a year for every $10 million of bond principal protected, according to data provider ICE Data Services. By contrast, buying puts on Oracle shares, which have fallen nearly 20% by the end of next year, could cost about $2,196 per 100 shares as of Friday, accounting for about 9.9% of the value of the hedged shares.
There’s good reason for money managers and lenders to at least consider reducing exposure now: This year, an MIT initiative published a report stating that 95% of organizations are seeing zero returns from productive AI projects. While some of the biggest borrowers right now are high-cash-flow companies, the tech industry has long been changing rapidly. Digital Equipment Corp. Companies such as those that were once big players may no longer be relevant. Bonds that currently seem safe could become significantly riskier over time and even default if profits from data centers fall short of companies’ current expectations, for example.
Credit default swaps affiliated with Meta Platforms Inc. began actively trading for the first time late last month following the jumbo bond sale. Derivatives tied to CoreWeave also began to be traded more actively. Its shares fell on Monday after the AI computing power provider cut its annual revenue forecast due to a delay in customer contract fulfillment.
In the years before the financial crisis, the market for high-grade single-name credit derivatives saw greater volume than it does today, as private traders at banks, hedge funds, bank loan book managers and others used the products to reduce or increase their exposure. Trading volume in single-name credit derivatives fell after Lehman’s collapse, and market participants say it is unlikely to return to pre-financial levels. There are now more hedging instruments available — including corporate bond exchange-traded funds — plus credit markets have become more liquid as bonds trade more electronically.
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Sal Naro, chief investment officer at Coherence Credit Strategies, thinks the recent surge in single-name CDS trading is temporary. The hedge fund has $700 million in assets under management.
“There is currently a lull in the CDS market due to the establishment of the data center,” Naro said. “Nothing would make me happier than to see the CDS market really come alive.”
But traders and strategists at banks said activity has increased for now. The overall volume of credit derivatives tied to individual companies rose nearly 6% in the six weeks ended Nov. 7, to about $93 billion from the same period a year earlier, according to Barclays’ Patel, who analyzed the latest trading data repository data.
“Activities have accelerated,” Dominique Toublan, Barclays’ head of U.S. credit strategy, said in an interview. “There is definitely more interest.”
–With help from David Marino.
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