For much of the past decade, the largest technology companies have had a ‘nice’ problem: they generated more cash than they knew what to do with. Nearly four years after the launch of ChatGPT, artificial intelligence (AI) is changing that.
The sums being committed to data centres, chips, power and the infrastructure needed to support AI are extraordinarily large; even for the mega-cap tech companies. Once free cash flow is no longer sufficient, debt and equity issuance are the next available options, and this is beginning to filter through to markets. US investment-grade corporate issuance is on course for a record year, with the hyperscalers becoming increasingly important borrowers.
That deserves attention, of course, but it does not mean that the corporate bond market is about to fall over altogether. The first distinction is between gross and net issuance. The headlines naturally focus on the enormous sums being raised, but companies are also refinancing existing bonds, and issuance elsewhere in fixed income has been more subdued. Look across the market as a whole and our estimates suggest net issuance remains broadly consistent with recent history. However, the concentration of issuance among the hyperscalers is also important, and could put pressure on pricing and spreads for other issuers.
There is plenty of debt being issued then, but less evidence, so far, of a general glut.
The second distinction is between ‘the market’ and ‘individual borrowers’. Credit markets, like equity markets, have started to discriminate between the hyperscalers. Spreads have widened somewhat, but the striking feature is the divergence between issuers rather than a wholesale rejection of technology debt. Oracle, in particular, stands out. This is healthy. Bond markets are supposed to discriminate between stronger and weaker issuers.
There is a tendency during investment booms to treat all the companies involved as a single trade. But balance sheets, cash generation and the terms on which infrastructure is financed matter. The return earned on hundreds of billions of dollars of AI investment will, ultimately, matter.
At Sarasin, we have no direct exposure to the issuers causing us most concern, but have started to build limited positions in those we believe are better placed and offer good value. As investors, we must remember that stress and volatility create opportunities as well as risks.
This is particularly relevant in the riskier high-yield bond market, which often presents opportunities. When investors become nervous about a fashionable part of the market, the repricing is rarely perfectly surgical, and we stand ready to exploit any indiscriminate widening of spreads.
This brings us to a slight nuance in our current positioning. Government bonds are, in our view, reasonably valued again. After the substantial rise in yields in recent years, investors are finally being paid a respectable income for lending to governments. We have therefore moved our government bond exposure back towards neutral. However, corporate bonds are different. We remain underweight credit but, importantly, not because we think excessive issuance is about to overwhelm the market. Our concern is more prosaic: spreads simply remain too tight. A corporate bond ought to give an investor the underlying government bond yield plus a reasonable spread to compensate for the additional risks of lending to a company. That extra compensation needs to cover defaults, downgrades, liquidity risk and the simple possibility that circumstances deteriorate.
At present, we do not think investors are being paid enough for taking those risks across much of the corporate bond market. Investment-grade spreads remain compressed, even as some lower-quality parts of the market have begun to differentiate more sharply. Yield and spread are not the same thing. A government bond can offer an attractive yield at the same time as a corporate bond offering a slightly higher yield can still be poor value.
So, we are watching the surge in debt issuance carefully. Dismissing it as a storm in a teacup would be complacent. Declaring it the beginning of a credit crisis would be equally premature.
For now, the warning lights are flashing around particular borrowers and financing structures rather than the corporate bond market as a whole. However, we are also concerned about the growing interconnections across the AI ecosystem and the potential broader risks these could create. These risks could become more significant, particularly if the extraordinary investment in AI fails to generate the revenues investors currently expect, but the investment conclusion today for us is simpler. Government bond yields have risen far enough to tempt us back. Corporate credit spreads have not.
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