2008 Again! One Article to Understand Wall Street's Hottest Trade: AI CDS

Barclays PLC Sponsored ADR (Barclays, BCS.US) released a comprehensive report on the credit default swap (CDS) market for AI-related companies, noting that with the substantial expansion of capital expenditures, the credit risk of AI-related companies has undergone significant repricing, with both CDS trading volumes and spreads showing sharp upward trends. On October 29, Barclays PLC Sponsored ADR reported that 10 core AI companiesincluding hyperscalers such as Alphabet Inc. Class C (GOOGL.US), Amazon.com, Inc. (AMZN.US), Meta (META.US), Microsoft Corporation (MSFT.US), and Oracle Corporation (ORCL.US), as well as chipmakers such as AMD (AMD.US), Broadcom Inc. (AVGO.US), and NVIDIA Corporation (NVDA.US)currently account for only 8% of the CDX Investment Grade index constituents, but already account for 16% of the index's implied credit risk. Barclays emphasized that over the past six months, the credit risk of all ten companies has widened, and all are currently near the upper end of their six-month trading ranges. (AI group: comparison of current 5-year CDS against six-month ranges) This means investors holding the investment-grade index have passively absorbed substantial AI-sector volatility risk. In addition, the basis between CDS and cash bonds for these core AI companies has turned positive, meaning the cost of buying default protection now exceeds the additional yield from holding these companies' bonds. According to institutional reports, this anomaly is mainly driven by a large number of institutions that do not hold the underlying bonds (such as equity funds and banks engaging in hedging) aggressively buying CDS to hedge massive AI capital expenditure and related loan risks. This technical dislocation is highly similar to 2008 in terms of the logic of credit hedging and basis distortion. Back then, a large number of institutions that did not hold subprime mortgage bonds (such as hedge funds and investment banks), motivated by macro bearish views or risk aversion, bought CDS protection to bet on default risk. This intensive "naked hedging" derivative buying pushed CDS spreads extremely high, even exceeding the credit spreads of the underlying cash bonds themselves, directly pushing the CDS-cash bond basis into positive territory. As Barclays published this report, financing demands from leading tech companies are continuing to pressure the market. Recently, Microsoft Corporation launched a bond issuance exceeding US$25 billion, Amazon.com, Inc. added more than US$48 billion in long-term debt in a single quarter, and Broadcom Inc. also plans to raise up to US$21 billion in early next year. These massive financings have further boosted hedging demand in the market, pushing CDS costs for the relevant companies to record highs. Chipmakers' Credit Profile Shifts, Spreads Widen Sharply In this wave of credit repricing, chipmakers' CDS spreads have widened most significantly. Six months ago, the CDS spreads of Broadcom Inc., AMD, and NVIDIA Corporation were still at the lowest levels in their category, hovering around 40 basis points. (AI group 5-year CDS, six months ago vs. now, ranked by six-month change) However, today these three companies' CDS spreads have jumped to the top, with Broadcom Inc.'s 5-year CDS surging 258% over six months, AMD up 177%, and NVIDIA Corporation up 172%. By comparison, AAA-rated Microsoft Corporation rose only 20%. Barclays noted in its report that as chip suppliers begin extending loans to customers to purchase their chips (i.e., vendor financing), the credit market has begun to view these companies as lenders with highly concentrated loan books. For example, after banks raised concerns about Anthropic's US$63 billion chip deal, Broadcom Inc. stepped in to provide a guarantee. Based on this, Barclays recommends buying Broadcom Inc. 5-year CDS protection as a macro strategy to hedge broader AI financing pressures. Basis Turns Positive and Hedging Demand Drives Trading Volume Surge The positive basis between CDS and cash bonds is the most notable technical feature of the current AI credit market. Over the past year, the basis for non-AI companies in the CDX Investment Grade index has remained largely negative, i.e., CDS spreads below bond spreads, but the AI group's basis has risen by about 50 basis points and turned positive. This positive basis is particularly pronounced among chipmakers and Oracle Corporation. (The CDS-cash bond basis for the AI group has now turned positive, while the basis for the non-AI group remains negative) This structural change has been accompanied by explosive growth in trading volume. As of October 23, the 4-week average weekly trading volume for hyperscalers reached approximately US$6 billion, surging about 740% year-over-year; chipmakers' weekly trading volume reached US$3 billion, surging 1,900% year-over-year. (CDS trading volumes for hyperscalers and semiconductor companies have increased significantly) Open interest data also confirms the continued inflow of funds. The net notional open interest for hyperscalers has doubled from about US$5 billion a year ago to US$20 billion, while chipmakers' has grown from about US$1.9 billion to US$8.6 billion. (The AI group's open interest has grown from about US$7 billion a year ago to more than US$28 billion currently) These 10 AI companies now account for nearly 14% of all single-name CDS open interest for Americas corporates, far above 4% a year ago. Curve Shape Divergence Highlights Stock-Specific Differences in Trading Strategies By analyzing the spread differential between 3-year and 5-year CDS curves, Barclays identified pricing anomalies in individual companies. For example, Amazon.com, Inc. and Alphabet Inc. Class C have comparable 5-year CDS levels (80-81 basis points), but Amazon.com, Inc.'s 3s5s curve (3-year vs. 5-year spread) is only 18 basis points, appearing excessively flat. (Absolute value of the current 3s5s CDS curve, and as a percentage of 5-year CDS) Barclays believes this may be related to buying pressure from a term loan by Amazon.com, Inc. in June, and recommends buying Amazon.com, Inc. 5-year protection or constructing a steepener trade. Earnings data subsequently confirmed the necessity of hedging: Amazon.com, Inc. reported third-quarter free cash flow consumption of US$33.5 billion and capital expenditures of US$77.3 billion. As the most liquid CDS name in the market, Oracle Corporation's basis is at the high end of the sample. (Comparison of where the current CDS-cash bond basis stands within the one-year range) Barclays recommends selling Oracle Corporation's 5-year basis, i.e., selling the 2032 maturity bonds while selling CDS protection, to bet on basis convergence. Previously, Oracle Corporation announced it would cap additional financing over the next few years at US$20 billion. In addition, Intel Corporation (INTC.US) is the only company in the sample whose basis remains negative (-14 basis points) and whose curve is relatively steep, mainly because it has not deeply participated in the vendor financing model of its peers. However, after weak guidance was announced, its stock price posted its largest single-day decline since 1982. High-Yield Market Microcosm: CoreWeave (CRWV.US) Default Protection Costs Remain Elevated Outside investment grade, CoreWeave, as the only directly related AI company CDS in the CDX High Yield index, has become a unique window for observing credit risk in data centers and neocloud providers. Currently, CoreWeave's 5-year CDS is priced on a "points upfront" basis at 15.5 points, a pricing method typically used for distressed debt, highlighting the market's heightened vigilance about its risk. (CoreWeave 5-year CDS, quoted in points upfront) Data shows that CoreWeave's weekly CDS trading volume has risen from US$32 million a year ago to US$302 million, with open interest increasing to US$850 million. (CoreWeave's weekly trading volume has risen from US$32 million a year ago to US$302 million, with open interest increasing to US$850 million) Although some analysts maintain an "overweight" rating on CoreWeave's bonds, the upfront cost of default protection at as high as 15.5 points indicates that the CDS market is pricing in a more stringent assessment of the potential default risk of its business model. This article is reproduced from "Wallstreetcn," author: Bao Yilong, GMTEight editor: Zheng Yuyang