A chill wind in the AI credit market

Credit winter has not come quite yet for the AI investment boom — but it is certainly getting colder out there as the leaves fall. Alphabet, Meta and Oracle returned to debt markets this week to sell tens of billions of dollars of additional bonds for access to chips and data centres, adding to a surge in such borrowing this year already estimated at about half a trillion dollars. The hyperscalers are, though, paying notably more than just a few months ago, when it seemed that growth in AI spending to fill the need for compute still had far to go.

On Monday, Oracle sold $10bn in bonds with coupons of 7 to more than 8.5 per cent, up from 5 to 7 per cent in an issue in February — though shareholders also took a hit, with a concurrent $10bn share sale. Alphabet, Google’s parent, issued 19-year euro-denominated bonds with a coupon of over 5.2 per cent as part of a €6bn sale this week, up from 4.5 per cent for selling debt of the same maturity and currency in May — and at a higher spread over core rates.

Government and corporate borrowers have fretted this year about being “crowded out” by supersized AI bonds offering juicier yields while interest rates have risen. But even as investors will watch the US midterm results for signs that Democratic gains might slow down data centre construction, something is changing in credit markets’ capacity to keep absorbing AI risk.

While these may not sound like large moves in borrowing costs, they add up in dollar terms given the sheer size of issuance that is undergirding investment plans. They raise pressure on the rates of return that will be required from AI spending and are striking for companies that mostly still have top credit ratings and core businesses throwing off cash. This is also reflected in investors paying up to hedge their debt exposure.

The cost to insure Alphabet’s dollar debt against a default in the next five years has risen to just under 1 per cent of principal, about the same as for Mexico, a government rated at the lowest levels of investment grade. Mark Zuckerberg has great hopes for Muse, Meta’s new personal AI agent. But in case he is wrong, investors are now pricing credit default swaps on the creator of the cutesy but compute-hogging agent at 1.2 per cent, in line with junk-rated South Africa.

It would be easier to brush off the market’s cooling on AI borrowers if the competition for capital they have unleashed, and the prolongation of higher interest rates and energy prices this year, were not exposing credit cracks elsewhere. Funds that flew high betting on the riskiest layers of European corporate debt in particular have come down with a bump. Yields on these bonds have blown out to double digits, more than higher-rated junk. Many of the borrowers are stuck in struggling industries such as broadband, and some such as Altice and Aston Martin were accused of using loose contractual terms to shift assets away from creditors.

There is a lesson here for bondholders sizing up AI debts that, even if they have far higher credit ratings, they are ultimately bets on who will be on the hook for the complex construction costs of data centres. Some parts of this market are still growing quickly, for example alternative asset managers extending loans secured against assets such as chips, but other creditors will be looking for protection from runaway spending.

Oracle, which was the first of the hyperscalers to start spending more than it generated in cash flow, signalled that $20bn will be the limit for new money it will raise from capital markets until 2030. Even if that may be a hard resolution to keep, it is significant that this kind of promise is coming into fashion. Investors have braced in case the AI trade implodes with a stock market bang. Instead it might start with a credit market whimper.