Key facts
- Demand for credit default swaps (CDS) on AI-linked companies has surged.
- CDS are derivatives that provide protection against a bond issuer failing to meet debt obligations.
- The market for single-name CDS is worth about $9 trillion.
- Trading linked to the technology sector in CDS reached nearly $650 million in Q2, a 20% increase from Q1.
- Oracle CDS trade around 200 basis points, indicating higher perceived risk compared to Nvidia (78 bps) and Meta (93 bps).
Shares in companies at the forefront of the artificial intelligence boom have faced pressure for weeks, and now their bonds are also experiencing strain. This has led to an increase in the cost of insuring debt issued by major technology firms such as Oracle, Nvidia, and Apple against default.
The rising demand for credit default swaps (CDS), a financial derivative that acts as insurance against a bond issuer failing to meet its debt obligations, reflects growing investor apprehension about the timeline for generating returns from the substantial investments being made in AI.
Technology companies have raised billions of dollars in debt this year to finance AI initiatives, with some, like Nvidia, entering the bond markets for the first time. However, the high cost associated with building out AI infrastructure has left some investors unconvinced about the sustainability of future profits, even in the face of strong earnings reports.
The market for single-name CDS, which covers the debt of a specific issuer, is valued at approximately $9 trillion, according to the International Swaps and Derivatives Association (ISDA). While this represents a small fraction of the global bond markets, which exceed $150 trillion in outstanding debt securities, trading activity has seen a notable increase. Average daily CDS trading across the market reached $16 billion in the second quarter, up from $13 billion a year prior. Trading specifically linked to the technology sector has grown significantly, reaching nearly $650 million in the second quarter, a 20% rise from the first quarter and a nearly 600% jump from the previous year, driven by new participants like Meta, Nvidia, and Alphabet.
However, CDS trading can be characterized by thin liquidity, meaning that even small transactions can disproportionately impact prices. Buyers typically purchase CDS through intermediaries like investment banks, which then find financial firms to issue the insurance policy. These are over-the-counter deals. The buyer pays a regular premium to the seller, who assumes the risk of a credit event. CDS are quoted as a credit spread in basis points (bps), with wider spreads indicating higher perceived risk. For instance, Oracle CDS are trading around 200 bps, Nvidia's around 78 bps, and Meta's near 93 bps, compared to an investment-grade CDS index trading around 53 bps.
While CDS offer a hedge for bondholders, a widening spread increases the cost of protection, potentially prompting investors to sell bonds and thereby raising borrowing costs for issuers. This can amplify concerns about creditworthiness and create a self-reinforcing cycle.