Is a new wave of the "subprime mortgage crisis" coming under the impact of AI?

Concerns over artificial intelligence technology disruptions are rapidly spreading across the global credit bond market, with asset sell-offs in various segments—from leveraged loans to collateralized loan obligations (CLOs)—raising alarms among investors about a systemic credit cycle.

According to Bloomberg indices, the recent yield spread on comparable global debt has widened by nearly 4 basis points, marking the largest increase since early November last year. The investment-grade bond market, long regarded as a safe haven, is showing signs of pressure, with spreads on investment-grade tech stocks widening rapidly. Since the global financial crisis, the resilience of the tech sector is being considered lower than that of broader investment-grade indices for the first time.

Meanwhile, Wall Street institutions warn that the default risk for highly leveraged borrowers in the AI and software industries is rising. Investor anxiety has turned into actual selling, with leveraged loans in the tech sector underperforming the broader market. US high-yield bond funds have experienced continued outflows over the past few weeks, signaling the end of months of gains in high-yield bonds.

Although volatility in high-rated credit indicators remains relatively mild, the strong correlation between private credit and public markets means that if core industries like tech suffer shocks, default risks could quickly spread, impacting the wider global credit bond sector.

Latest market data shows that in February, the Bloomberg US Leveraged Loan Index declined by 1.34% on average, the largest monthly drop since September 2022, mainly due to loans in the software and services sectors, leading many debts into distress. Meanwhile, JPMorgan warns that US CLO asset pools worth between $40 billion and $150 billion are facing risks from AI disruption.

Spread Movements Between Investment Grade and High-Yield Bonds

Once considered safe havens, investment-grade bonds are also showing rare cracks. According to JPMorgan, companies related to AI now account for 14% of the investment-grade index, with related debt expanding rapidly to $1.2 trillion, surpassing the US banking sector to become the largest sector within the index. Under market pressure, the spread between tech investment-grade bonds and the overall market has widened significantly.

This credit bond fissure is affecting markets worldwide. Bloomberg indices indicate that the yield premium on Asian investment-grade USD bonds has recently experienced its largest weekly increase since November last year. Clement Chong, head of Asian fixed income credit research, notes that valuations in Asian markets have already tightened in line with the US, making them vulnerable to local volatility.

High-Yield Bonds and Leveraged Loans Under Pressure

As concerns about default risks in the software industry grow, higher-risk credit sectors are bearing the brunt. Following recent high-yield bond issuances, investors have rushed to sell, pressuring prices of junk bonds. According to LSEG Lipper data, US high-yield bond funds have experienced outflows for multiple consecutive weeks.

Additionally, the leveraged loan market for the tech sector is also weakening, with declines exceeding those of broader leveraged loan indices in the US and Europe. Recent events, such as the collapse of UK mortgage lender Market Financial Solutions and bankruptcies of First Brands Group and Tricolor Holdings, have further fueled worries about lax underwriting standards in credit markets, sparking speculation about assets being re-mortgaged.

Risks of Private Credit Bonds Spreading to Public Markets

Deeper market concerns center on the systemic contagion risk posed by private credit bonds. UBS warns that because borrowers often rely on dual financing in private and syndicated loan markets, there is significant overlap in issuers and industry exposure. Data shows that the service and tech sectors account for 15% to 20% of leveraged loan portfolios, closely matching the characteristics of private credit markets.

UBS credit strategist Matthew Mish notes that the top 20 direct lending institutions not only dominate private credit asset management but also hold large positions in business development companies (BDCs), leveraged loans, and high-yield bonds. This tight interconnectedness means that if AI shocks cause default rates in software and related sectors to spike, the contagion could quickly spill over into public markets, widening spreads and impairing liquidity, thereby posing a substantial challenge to the capital adequacy of global banks and insurers during economic downturns.

Mish summarizes in his report that while the private credit market has not yet fully entered a crisis, warning signs are emerging. The key trigger will likely be shocks to critical industries like software. Due to high leverage, industry concentration, and limited transparency in the private market, accurately assessing macro risks is extremely difficult. Investors should closely monitor leading indicators such as default rates and valuation changes to guard against potential systemic risks.

Leverage Loan Market Cooling Rapidly

Leverage loans, a vital financing source for below-investment-grade companies, are feeling the first wave of pressure from AI disruptions. According to Bloomberg, worries about AI undermining traditional business models have led to a rush to sell highly software-dependent borrowers. As loan prices fall to multi-month lows, new loan issuance in the US has also dropped to its lowest level since May last year.

JPMorgan strategists warn that refinancing risks in the software sector are intensifying. Data shows approximately $51 billion of software debt rated B- or below will mature by 2028, with another $50 billion due in 2029. Given the current limited capacity of the private credit market to absorb syndicated assets, these debts will face significant refinancing challenges ahead.

CLO Asset Pools Sound AI Risk Alarms

The risks in leveraged loan underlying assets are directly transmitting to structured products. Recently, Anthropic PBC released its powerful Claude chatbot, triggering a sell-off in software loans and prompting CLO managers to urgently reassess their AI exposure. According to JPMorgan analysis, about $40 billion to $150 billion of CLO loans are at high risk of disruption due to their industry’s close ties to AI.

JPM strategists Rishad Ahluwalia notes that beyond focusing on the software industry itself, investors should consider the broader impact of AI disruption on CLO credit risk. They point out that although economists expect AI’s penetration into the economy to be gradual, excessive leverage in the financial markets related to AI could trigger unwelcome revaluations.

Risk Alerts and Disclaimers

Market risks are present; investments should be made cautiously. This article does not constitute personal investment advice and does not consider individual user objectives, financial situations, or needs. Users should determine whether any opinions, views, or conclusions herein are suitable for their specific circumstances. Invest at your own risk.