Explainer-Why are credit default swaps unnerving AI investors?
FILE PHOTO: An AI (Artificial Intelligence) sign is seen at the World Artificial Intelligence Conference (WAIC) in Shanghai, China July 6, 2023. REUTERS/Aly Song/File Photo
Read a summary of this article on FAST.
Get bite-sized news via a new
cards interface. Give it a try.
Click here to return to FAST
Tap here to return to FAST
FAST
LONDON, Oct 15 : The cost of insuring against the risk of potential US tech defaults has hit record levels in the latest sign of credit stress building in the so-called AI trade, especially for data centres dependent on future revenue.
Although shares in companies driving the AI boom are still among the biggest gainers on global equity markets this year, many have fallen sharply in the past few weeks, as investors reassess the cost of capital against a backdrop of rising interest rates and inflation.
There are also doubts among some investors and analysts about when, and in some cases, if, the billions of dollars pouring into data centres, computer power and other infrastructure will pay off.
Demand for AI-linked credit default swaps (CDS), a form of insurance against default that gained prominence during the 2008 financial crisis, meanwhile has surged, even for heavyweights like Apple, Amazon and Microsoft.
Guess Word
Crack the word, one row at a time
Buzzword
Create words using the given letters
Mini Sudoku
Tiny puzzle, mighty brain teaser
Mini Crossword
Small grid, big challenge
Word Search
Spot as many words as you can
For some of their more heavily indebted competitors, suppliers and customers the cost of CDS has risen even faster.
WHAT IS A CDS?
A derivative that provides protection against the risk that a bond issuer, whether a company or government, fails to meet its debt obligations.
Bond investors expect to receive interest payments and repayment of principal when a bond matures, but they bear the risk that those payments may not be made.
Buying CDS helps investors hedge that risk by effectively providing insurance against a default or other credit event. If the value of a bond drops for any reason, an investor might add to their CDS holdings to help offset that, for example.
None of the companies whose CDS have risen recently have defaulted on their obligations or signalled that they may do so.
IS THIS A BIG MARKET?
The market for single-name CDS, which cover the bonds of a single issuer, is worth about $9 trillion, the International Swaps and Derivatives Association (ISDA) said.
That is a small portion of global bond markets, which have more than $150 trillion of debt securities outstanding, Bank for International Settlements data shows.
The biggest CDS market is for government debt.
Average daily CDS trading across the market was $16 billion in the second quarter, up from $13 billion a year earlier, the most recent data from the Depository Trust & Clearing Corporation shows. Saudi Arabia is the most actively traded.
But average daily trades, even for large companies, can sometimes be in the single digits, meaning small transactions can have an outsized impact on prices.
WHO BUYS CDS?
Bond investors typically buy CDS through an intermediary, often an investment bank, which then finds a financial firm to issue an insurance policy on the bonds. These are “over-the-counter” deals that do not go through a central clearing house.
Hedge funds also participate in the market, selling CDS to investors seeking to hedge exposure.
The buyer pays a fee, called a premium, at regular intervals to the seller, which assumes the risk of a credit event.
CDS are quoted as a credit spread, which is the number of basis points (bps) that the seller of the derivative charges the buyer for providing protection. The higher the perceived risk of a credit event, the wider the spread.
A CDS quoted at 100 bps costs $1 annually to insure every $100 of debt.
WHAT’S GOING ON WITH TECH CDS?
CDS for CoreWeave, a heavily indebted data centre operator at the eye of the current storm, have risen above 1,000 bps, S&P Global Market Intelligence data show.
They suggest a roughly 63 per cent chance of a default over the next five years, up from around 30 per cent a year ago.
Tech CDS moves reflect investor concern over how quickly massive investments in AI will translate into profits, and whether heavily indebted companies can generate returns fast enough to service mounting interest costs.
Oracle has seen its CDS trade at nearly 300 bps, well above those of other AI-linked companies.
Nvidia CDS have also risen sharply in recent weeks to around 90 bps, Meta CDS are trading around 104 bps.
By comparison, an index of investment-grade CDS is trading around 60 bps.
WHAT TRIGGERS A CDS PAYOUT?
A CDS pays out following a credit event, which can include a bankruptcy or a failure by an issuer to make bond payments.
When concerns about an issuer’s creditworthiness increase, demand for protection typically rises, widening CDS spreads.
Payouts are not a given. When Swiss lender Credit Suisse collapsed and was taken over by rival UBS in 2023, the EMEA Credit Derivatives Determinations Committee (CDDC) ruled that event would not trigger a CDS payout.
IF IT’S INSURANCE, WHAT’S THE PROBLEM?
CDS provide a hedge for bondholders. But rising perceived risk pushes up the cost of protection, which can prompt investors to sell bonds and raise borrowing costs for issuers.
That can amplify concerns about creditworthiness and potentially create a self-reinforcing cycle.
Source: Reuters
Sign up for our newsletters
Get the CNA app
Stay updated with notifications for breaking news and our best stories
Get WhatsApp alerts
Join our channel for the top reads for the day on your preferred chat app
Get bite-sized news via a new
cards interface. Give it a try.
Click here to return to FAST
Tap here to return to FAST
FAST
