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

Concerns over artificial intelligence technology disruptions are rapidly spreading to the global credit bond market, with asset sell-offs across 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 considered 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 viewed as weaker than the broader investment-grade index 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 junk bond funds have experienced continued outflows over the past few weeks, and the rally in high-yield bonds is facing an end.

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

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

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 US banking as the largest sector in 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 show that the yield premium on Asian investment-grade dollar bonds recently experienced the largest weekly increase since November last year. Clement Chong, head of Asian fixed income credit research, notes that valuation in Asian markets has tightened in line with the US, making it vulnerable to local volatility.

Junk 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 junk bond prices. Data from LSEG Lipper shows that US junk bond funds have experienced outflows for several consecutive weeks.

Additionally, the leveraged loan market for tech companies is also weak, with declines exceeding those of broader US and European leveraged loan indices. Recent events, such as the collapse of UK mortgage lender Market Financial Solutions and bankruptcies of First Brands Group and Tricolor Holdings, have heightened fears of lax underwriting standards in credit markets, fueling speculation about asset re-pledging.

Risks of Systemic Spread from Private Credit to Public Markets

Deeper market concerns center on the potential systemic contagion from 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.

Matthew Mish, a credit strategist at UBS, notes that the top 20 direct lending institutions not only dominate private credit asset management but also hold large positions in 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 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 crisis, the seeds of a crisis are present. The key trigger would be shocks to critical industries like software. Due to high leverage, sector concentration, and limited transparency, macro risks are difficult to assess accurately. Investors should closely monitor leading indicators such as default rates and valuation changes to guard against potential systemic risks.

Leverage Loan Market Rapidly Cooling

Leverage loans, a vital funding source for below-investment-grade companies, are feeling the first wave of pressure from AI disruptions. Bloomberg reports that worries about traditional business models being overturned by AI have hit highly dependent software borrowers hardest. Loan prices have fallen to multi-month lows, and new loan issuance in the US has dropped to its lowest since May last year.

JPMorgan strategists warn that refinancing risks in the software sector are intensifying. Data shows that about $51 billion of software debt rated B- and 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 face significant refinancing challenges ahead.

CLO Asset Pools Sound AI Risk Alarm

The underlying asset risks of leveraged loans 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 exposure to AI-related sectors.

Rishad Ahluwalia, a JPMorgan strategist, states that beyond focusing on the software industry itself, investors should consider the broader impact of AI disruption on CLO credit risk. While economists expect AI’s economic penetration to be gradual, excessive leverage in financial markets related to AI could trigger uncomfortable re-pricing expectations.

Disclaimer: The content and data in this article are for reference only and do not constitute investment advice. Verify before use. Operate at your own risk.