(Bloomberg) — As tech companies prepare to borrow hundreds of billions of dollars to fuel investments in artificial intelligence, lenders and investors are increasingly looking to protect themselves from things going wrong.
Banks and asset managers are increasingly trading in derivatives that promise payments if individual tech companies, known as hyperscalers, default on their debts. Demand for credit protection has caused the cost of Oracle’s bond credit derivatives to more than double since September. Meanwhile, the volume of credit default swaps linked to Barclays soared to about $4.2 billion in the six weeks to Nov. 7, said Barclays credit strategist Jigur Patel. That’s up from less than $200 million in the same period last year.
“We’re seeing a resurgence of client interest in the single-name CDS discussion that had waned in recent years,” said John Servidea, global co-head of investment grade finance at JPMorgan Chase. “Hyperscalers are highly valued, but they’re really growing as borrowers and people get more exposure, so naturally we’re also seeing more conversations with clients about hedging.”
A representative for Oracle declined to comment.
Traders say trading activity is still small compared to the amount of debt expected to flood the market. But the rising demand for hedging is a sign that technology companies are increasingly dominating capital markets as they seek to reshape the global economy with artificial intelligence.
Investment-grade companies could sell about $1.5 trillion in debt over the next few years, according to JPMorgan strategists. A series of big AI-related bond sales have hit the market in recent weeks, including Meta Platforms Inc.’s $30 billion bond sale, the biggest corporate bond sale this year in the U.S., and Oracle Inc.’s $18 billion offering in September.
Technology companies, utilities and other AI-related borrowers now make up the largest portion of the investment-grade market, according to a report released last month by JPMorgan. They have been replaced by banks, which had long held the largest share. Junk bonds and other major debt markets will also see a surge in borrowing as companies build thousands of data centers around the world.
Traders say banks are now some of the biggest buyers of single-name credit default swaps on tech companies, and their exposure to tech companies has soared in recent months.
Another source of demand for derivatives is equity investors looking for a relatively cheap hedge against falling stock prices. Buying Friday’s protection would cost about 1.03 percentage points if Oracle defaults within the next five years, equating to about $103,000 per year for every $10 million in bond principal protected, according to data provider ICE Data Services. By contrast, buying a put on Oracle stock, which is expected to fall about 20% by the end of next year, could cost about $2,196 per 100 shares as of Friday, representing about 9.9% of the value of the stock protected.
There are good reasons for asset managers and lenders to at least consider reducing their exposure now. An MIT initiative released a report this year showing that 95% of organizations see zero return from their generative AI projects. Today, some of the largest borrowers are companies with large cash flows, but the technology industry has long been changing rapidly. Companies that were once big players, such as Digital Equipment Corp., can become obsolete. For example, if profits from a data center fall short of a company’s current expectations, a bond that seems safe now could become much riskier over time and could even default.
Credit default swaps related to Meta Platforms Inc. began active trading for the first time late last month following the sale of jumbo bonds. Derivatives related to CoreWeave are also starting to be more actively traded. The company’s stock price plunged on Monday after the provider of AI computing power lowered its annual revenue forecast, citing delays in fulfilling customer contracts.
In the years before the financial crisis, the high-end single-name credit derivatives market was more heavily traded than it is today, as proprietary traders such as banks, hedge funds, and bank loan book managers used the products to reduce or increase risk. Trading volumes of single-name credit derivatives declined after the collapse of Lehman Brothers, and market participants say they are unlikely to return to pre-financial levels. There are now more hedging instruments, such as corporate bond exchange-traded funds, and more electronic trading of bonds, making the credit markets themselves more liquid.
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Sal Naro, chief investment officer at Coherence Credit Strategies, believes the recent increase in single-stock CDS trading is temporary. His hedge fund manages $700 million in assets.
“Currently, the CDS market is plummeting due to the expansion of data centers,” Naro said. “Nothing would make me happier than to see the CDS market really come back.”
But for now, activity is on the rise, traders and bank strategists said. The total value of credit derivatives tied to individual companies rose about 6% from a year earlier to about $93 billion in the six weeks ending Nov. 7, according to Barclays’ Patel, who analyzed the latest trade repository data.
“There’s been a lot of activity,” Dominique Toubran, head of U.S. credit strategy at Barclays, said in an interview. “Interest is definitely growing.”
–With assistance from David Marino.
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