AI bubble fears are creating new derivatives

That fear is breathing new life into the market for credit derivatives, where banks, investors and others can protect themselves against borrowers larding on too much debt and becoming less able to pay their obligations. Credit derivatives tied to single companies didn’t exist on many high-grade Big Tech issuers a year ago, and are now some of the most actively traded US contracts in the market outside of financial sector, according to Depository Trust & Clearing Corp.

While contracts on Oracle have been active for months, in recent weeks, trading on Meta Platforms and Alphabet has become much more active. Contracts tied to about $895 million of Alphabet debt are outstanding, after netting out opposite trades, while around $687 million is tied to Meta debt. With AI investments expected to cost more than $3 trillion, much of which will be funded with debt, hedging demand can only grow, according to investors. Some of the richest tech companies are rapidly turning into some of the most indebted.

“This hyperscaler thing is just so ginormous and there’s so much more to come that it really begs the question of ‘do you want to really be nakedly exposed?’,” said Gregory Peters, co-chief investment officer at PGIM Fixed Income. Credit derivatives indexes, which offer broad default protection against a group of index members, aren’t enough, he said.

Bloomberg

Six dealers quoted Alphabet CDS at the end of 2025 compared with one last July, while the number of Amazon.com Inc. CDS dealers rose to five, from three, DTCC data show.

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Some providers even offer baskets of hyperscalers’ CDS, mirroring baskets of cash bonds that are rapidly being developed. Activity among hyperscalers really picked up in the fall when news around the debt requirements of these companies became front and center. A Wall Street dealer said his trading desk is able to regularly quote markets of $20 million to $50 million for a lot of these names, which didn’t even trade a year ago.

For now, hyperscalers are having little trouble financing their plans in the debt market. Alphabet’s $32 billion debt sale in three currencies this week drew orders for many times more that amount within 24 hours. The technology company successfully sold 100-year bonds, an astonishing move in an industry where businesses can rapidly become obsolete.Morgan Stanley expects borrowing by the massive tech companies known as hyperscalers to reach $400 billion this year, up from $165 billion in 2025. Alphabet said its capital expenditures will reach as much as $185 billion this year to finance its AI build-out. That kind of exuberance is what has some investors worried. London hedge fund Altana Wealth last year bought protection against Oracle defaulting on its debt. The cost was about 50 basis points a year for five years, or $5000 a year to protect $1 million of exposure. The cost has since risen to around 160 basis points.

BANK USERS
Banks that underwrite hyperscaler debt have been significant buyers of single-name CDS lately. Deals to develop data centers or other projects are so big and happening so fast underwriters are often looking to hedge their own balance sheets until they can distribute all of the loans tied to them.

“Expected distribution periods of three months could grow to nine to 12 months,” said Matt McQueen, head of credit, securitized products and muni banking at Bank of America Corp., referring to loans on projects. “As a result, you’re likely to see banks hedge some of that distribution risk in the CDS market.”

Wall Street dealers are rushing to meet the demand for protection.

“Appetite for newer basket hedges can be expected to grow,” said Paul Mutter, formerly the head of US fixed income and global head of fixed income sales at Toronto-Dominion Bank. “More active trading of private credit will create additional demand for targeted hedges.”

Some hedge funds see banks’ and investors’ demand for protection as an opportunity to profit. Andrew Weinberg, a portfolio manager at Saba Capital Management, described many CDS buyers as “captive flow” clients — bank lending desks or credit valuation adjustments teams for example.

Leverage remains low at most of the big tech companies, while bond spreads are only slightly tighter than the corporate index average, which is why so many hedge funds, including his, are willing to sell protection, according to Weinberg.

“If there’s a tail risk scenario, where will these credits go? In a lot of scenarios, the big companies with strong balance sheets and trillion dollar market caps will outperform the general credit backdrop,” he said.

But for some traders, the frenzy of bond selling has all the hallmarks of complacency and mispriced risk.

“The sheer amount of potential debt suggests that these companies’ credit risk profiles could come under some pressure,” said Rory Sandilands, a portfolio manager at Aegon Ltd., who says he has more CDS trades on his book than a year ago.