High Yield: A calming pill for investors spooked by the AI boom?
Many bond investors are viewing the artificial intelligence (AI) boom with suspicion. In this article, Jamil Bouallai explains why High Yield securities from software companies can still offer opportunities – and reveals which segments he is considering.
Author: Jamil Bouallai, Portfolio Manager Global Fixed Income
Three key points about bonds, AI, and the opportunities offered by high yield:
- Bond investors are increasingly concerned about the impact of the AI boom.
- Software companies in particular could struggle with this future technology. The private credit and leveraged loan asset classes would be most exposed here.
- High Yield bonds are significantly less exposed – and could even benefit from this environment.
Credit investors are famous for two things: reading footnotes and assuming disaster. When it comes to AI, these instincts have morphed into a curious mix of skepticism and anxiety.
Skepticism prevailed towards the end of last year as technology giants kept outbidding each other with ever-larger AI investment plans, as evidenced by Google's latest jumbo issuance of over USD 32 billion of debt, including a rare 100-year bond and 5 debt tranches denominated in CHF. This mindset has faded and given way to anxiety since the buzz from Anthropic's Claude Cowork last month. News of the latest plugin from the US AI start-up has reverberated through the markets, as investors grappled with the prospect that AI could undermine the business models of technology and data companies.
High Yield with positive returns since the beginning of the year
Private credit and leveraged loans have the largest software exposure and were therefore hit the hardest. Moreover, their software exposure is skewed towards lower quality (B- or lower) and weaker vintages (2020-2021), when leveraged buyout (LBO) deals were done at higher leverage, looser covenants and lower interest rates.
While some of those traits can be shared by the High Yield bond issues, the software exposure of the High Yield universe remains limited at less than 5%. Despite the High Yield technology sector spreads widening by 145 bps in the last 4 weeks, the impact on broad High Yield indices was limited: The ICE BofA US High Yield Index still exhibits positive total returns (+0.71%) year to date. The Morningstar LSTA US Leveraged Loan Index is down (-0.4%), penalized by its high software exposure (-4.3%).
Technology exposure across leveraged finance (share in %)
It's interesting to compare today's loans and private credit software exposure (see chart above) to the energy exposure of High Yield in 2015. The shale capex boom between 2010 and 2014 boosted energy exposure to around 15% of the HY index before experiencing weakness in 2015 to 2016 and spilling over other areas.
That notwithstanding, the software selloff that started four weeks ago has been indiscriminate. More levered capital structures were hit harder with little differentiating between software businesses and their capability to resist AI disruption. As is often the case when a risk emerges, investors tend to sell first and ask questions later. It will take time to identify the winners and losers, but in our view, there are already opportunities out there.
Technology historically traded at a premium (Option Adjusted Spread OAS in basis points)
High Yield also appears well-positioned when taking the AI skeptic point of view. The funding of the capital expenditure "binge" has dominated the AI credit debate over the last six months. It seems to be widely accepted now that leveraged loans and high yield bonds will only help finance a tiny portion of the colossal AI spending, estimated to reach up to USD 5 trillion by 2030, as estimated among other sources by the U.S. broker JP Morgan. On the other hand, private credit is expected to pick up a large part of the bill.
If AI spending has been a key worry for investment grade investors, it has so far also been an opportunity for High Yield, providing a lifeline to highly leveraged telecom infrastructure companies such as Lumen (Fiber networks) or CommScope (Telecom Equipment).
Newly issued HY bonds to build AI Infrastructure are outperforming bonds from Software companies (Total Return in %)
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High Yield has only recently started to see its share of "pure play" AI issuance. Interestingly, most of it has concerned powered shells, i.e. the datacenters which together with Nvidia's GPUs and Google's TPUs, can be seen as the picks and spades of the AI gold rush.
Those deals are interesting to look at as they share many features with infrastructure project finance. While not being completely isolated from the credit profile of their parent issuer, we see most of the risk lying during the construction phase. This phase should close in the next six to twelve months for most of the outstanding bonds.
Focus on issuers with strong experience building data centers
After that construction phase, we see limited operational risks as the debt could be quickly amortized by the rents collected from high quality tenants such as Google or Amazon. Furthermore, participating selectively in the early deals from the issuers with a strong experience building data centers helps to reduce the risk from supply chain constraints – many datacenters' projects will be started, and some of them might not be completed on time.
Ultimately, this approach also reduces the risk of potential overbuilding, even if demand may seem insatiable at first glance.
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