Concerns triggered by the disruptive force of artificial intelligence are rapidly spreading to global credit markets. From leveraged loans to collateralized loan obligations (CLOs), asset sell-offs across various segments are alerting investors to a potential systemic credit cycle.
According to Bloomberg indices, the yield premium on global comparable debt recently widened by nearly 4 basis points, marking the largest increase since early November of last year. The investment-grade bond market, long considered a safe haven, is showing signs of stress. Spreads on investment-grade tech stocks have widened rapidly, with the sector's perceived stability falling below that of the broader investment-grade index for the first time since the global financial crisis.
Simultaneously, Wall Street institutions are warning of rising default risks among highly leveraged borrowers in the AI and software sectors. Investor anxiety has translated into actual selling pressure. Not only are leveraged loans in the tech sector underperforming the broader market, but U.S. junk bond funds have also experienced sustained outflows in recent weeks, threatening to end a multi-month rally in high-yield bonds.
Although volatility in high-grade credit metrics remains relatively moderate for now, the high correlation between private credit and public markets suggests that if core sectors like technology are hit, default risks could quickly spread, affecting broader global credit markets.
Recent market data shows that the Bloomberg US Leveraged Loan Index fell an average of 1.34% in February, the largest monthly decline since September 2022, primarily dragged down by loans in the software and services sectors, pushing significant debt into distressed territory. Meanwhile, JPMorgan Chase has warned that U.S. CLO asset pools, valued between $400 billion and $1.5 trillion, are facing risks from AI disruption.
The investment-grade bond market is also showing unusual cracks. JPMorgan data indicates that AI-related companies now account for 14% of the investment-grade index, with related debt swelling rapidly to $1.2 trillion, surpassing the U.S. banking sector to become the largest component of the index. As market pressure mounts, the spread between tech-related investment-grade bonds and the broader market index has widened substantially.
This credit market stress is spreading globally. According to Bloomberg indices, the yield premium on Asian investment-grade US dollar bonds recently saw its largest weekly increase since last November. Clement Chong, Head of Fixed Income Credit Research for East Asia Investments, stated that Asian market valuations have tightened in sync with the U.S., leaving them vulnerable to local volatility.
As investor concerns over default risks in the software sector intensify, riskier credit segments are bearing the brunt. Following several recent high-yield bond issuances, investors rushed to sell, putting pressure on junk bond prices. Data from LSEG Lipper shows that U.S. junk bond funds have experienced consecutive weeks of outflows.
Furthermore, the leveraged loan market for the tech sector is also underperforming, declining more sharply than the broader U.S. and European leveraged loan indices. Recent events in credit markets, such as the collapse of UK mortgage lender Market Financial Solutions and the earlier bankruptcies of First Brands Group and Tricolor Holdings, have heightened concerns about loose credit underwriting standards and sparked speculation about asset re-pledging.
A deeper market concern involves the potential for systemic contagion risk originating from the private credit market. UBS Group AG has warned that due to frequent dual financing by borrowers in both the private and syndicated loan markets, there is significant overlap in issuer and sector exposure. Data shows that the services and technology sectors account for 15% to 20% of leveraged loan portfolios, a characteristic highly consistent with the private credit market.
Matthew Mish, a credit strategist at UBS Group AG, pointed out that the top 20 direct lenders not only dominate assets under management in private credit but also hold significant positions in Business Development Companies (BDCs), leveraged loans, and high-yield bonds. This tight interconnectedness means that if an AI-driven shock causes a spike in defaults in sectors like software, the contagion effect could quickly spread to public markets, leading to wider spreads and impaired liquidity, thereby posing a substantial test to the capital adequacy of global banks and insurers during an economic downturn.
In his report, Matthew Mish concluded that while the private credit market is not yet in a full-blown crisis, the seeds of one have been sown. A key trigger would be a shock to critical sectors like software. Due to issues such as high leverage, sector concentration, and limited transparency in the private market, accurately assessing macro risks is extremely difficult. Investors need to closely monitor leading indicators like default rates and valuation changes to guard against potential systemic risks.
The leveraged loan market, a crucial funding source for below-investment-grade companies, is feeling the initial pressure from the AI shock. According to Bloomberg, fears that traditional business models will be disrupted by AI are hitting borrowers heavily reliant on software businesses particularly hard. As loan prices fall to multi-month lows, the volume of new loan issuance in the U.S. has also plummeted to its lowest level since May of last year.
JPMorgan strategists note that refinancing risks in the software sector are intensifying. Data indicates that approximately $51 billion of software sector debt rated B- and below is set to mature by 2028, with another $50 billion maturing in 2029. Given the current limited capacity of the private credit market to absorb syndicated assets, this debt faces severe refinancing challenges ahead.
Risks from the underlying assets of leveraged loans are directly transmitting to structured products. Previously, the release of a powerful Claude chatbot by Anthropic PBC triggered selling in software loans, prompting CLO managers to urgently review their AI exposure within their portfolios. Analysis by JPMorgan suggests that between $400 billion and $1.5 trillion of CLO loans are vulnerable to disruption due to their exposure to industries highly susceptible to AI risk.
Rishad Ahluwalia, a strategist at JPMorgan, stated that beyond focusing solely on the software industry itself, investors should consider the broader impact of widespread AI disruption on the overall credit risk of CLOs. Strategists noted that while economists expect the penetration of AI into the economy to be gradual, excessive leverage in financial markets related to AI could trigger an uncomfortable reset of expectations.