The AI debt crisis is a ticking time bomb, and traders are scrambling to find safety. As tech giants prepare to borrow vast sums for AI investments, lenders and investors are seeking protection from potential disasters.
The AI Debt Bomb: A Looming Threat
Tech companies are on a borrowing spree, with plans to raise hundreds of billions to fund their AI ambitions. But here's where it gets controversial: lenders and investors are increasingly hedging their bets, concerned about the potential risks.
Banks and money managers are trading derivatives to protect against tech company defaults. The cost of credit derivatives has soared, with Oracle Corp. seeing a doubling of costs since September. Trading volume for credit default swaps has also skyrocketed, reaching $4.2 billion in just six weeks, according to Jigar Patel of Barclays Plc.
John Servidea, global co-head of investment-grade finance at JPMorgan Chase & Co., notes a renewed interest in single-name CDS discussions. He explains, "Hyperscalers are highly rated, but their borrowing has increased, exposing more people. Naturally, clients want to hedge."
The trading activity, though small compared to the expected debt flood, is a sign of the tech industry's dominance in capital markets. Investment-grade companies could sell a staggering $1.5 trillion in bonds in the coming years, with AI-related borrowers leading the charge.
The Tech Takeover: Dominating Capital Markets
Tech companies, utilities, and AI-related borrowers now make up the largest part of the investment-grade market, surpassing banks which once dominated. Junk bonds and other debt markets will also see a borrowing wave as firms build global data centers.
Some of the biggest buyers of single-name credit default swaps on tech companies are banks themselves, whose exposure to tech has surged. Equity investors are also seeking relatively cheap hedges against share drops, with protection costs significantly lower than put options.
There are valid reasons for money managers and lenders to consider reducing exposure. An MIT report this year revealed that 95% of organizations are getting no returns from generative AI projects. While some borrowers have high cash flow, the technology industry is notoriously fast-changing. Once-dominant companies like Digital Equipment Corp. can quickly become obsolete, and seemingly safe bonds may prove riskier over time.
Credit default swaps tied to Meta Platforms Inc. and CoreWeave have started actively trading, with CoreWeave's shares tumbling after a revenue forecast cut.
In the years leading up to the financial crisis, the high-grade single-name credit derivatives market saw more volume. However, trading volume dropped post-Lehman, and it's unlikely to return to pre-crisis levels. Today, there are more hedging instruments, and credit markets have become more liquid with increased electronic bond trading.
Sal Naro, chief investment officer of Coherence Credit Strategies, sees the recent CDS trading increase as temporary, due to the data center build-out.
But for now, activity is on the rise, according to traders and strategists. Overall volume for credit derivatives tied to individual companies has increased by about 6% over the past six weeks, reaching $93 billion.
"Activity has picked up," says Dominique Toublan, head of US credit strategy at Barclays. "There's definitely more interest."
For more insights, check out our podcast with Oaktree about the lack of discipline in the AI rush.
Stay tuned for more updates on this developing story, and don't forget to share your thoughts in the comments! Are you concerned about the AI debt explosion? What steps do you think should be taken to mitigate potential risks?
