As technology companies prepare to secure hundreds of billions of dollars to fuel their expansive investments in artificial intelligence, lenders and investors are increasingly seeking methods to safeguard themselves against potential financial downturns. This trend has led to a significant surge in the trading of derivatives designed to offer payouts should individual tech giants, often referred to as hyperscalers, default on their substantial debts.

Demand for credit protection has markedly increased, evidenced by the cost of credit derivatives on Oracle Corp.'s bonds more than doubling since September. Furthermore, trading volume for credit default swaps (CDS) tied to Oracle escalated dramatically to approximately $4.2 billion over the six weeks ending November 7, a stark contrast to less than $200 million in the same period the previous year, according to Barclays Plc credit strategist Jigar Patel. John Servidea, global co-head of investment-grade finance at JPMorgan Chase & Co., noted a "renewed interest from clients in single-name CDS discussions," attributing this to the hyperscalers' growth as borrowers and the consequent increase in investor exposure, naturally leading to more hedging dialogues. An Oracle representative declined to comment on the matter.

While the current trading activity remains modest compared to the vast amount of debt anticipated to enter the market, this growing demand for hedging instruments signals the increasing dominance of tech companies in capital markets as they endeavor to transform the global economy with artificial intelligence. JPMorgan strategists project that investment-grade companies could issue around $1.5 trillion in bonds in the coming years. Recent weeks have already seen major AI-related bond sales, including Meta Platforms Inc.'s $30 billion offering in late October, which was the largest US corporate issue of the year, and Oracle's $18 billion sale in September. A recent JPMorgan report highlights that tech companies, utilities, and other borrowers linked to AI now constitute the largest segment of the investment-grade market, having overtaken banks. This wave of borrowing is also expected to impact junk bonds and other major debt markets as firms globally construct thousands of data centers.

The primary purchasers of single-name credit default swaps on tech companies are currently banks, whose exposure to the tech sector has surged in recent months. Another significant source of demand comes from equity investors, who view these derivatives as a relatively cost-effective hedge against potential drops in share prices. For instance, protecting $10 million of Oracle bond principal against default within five years cost approximately $103,000 annually as of a recent Friday. In comparison, purchasing a put option on Oracle shares to guard against a nearly 20% decline by the end of next year would cost about $2,196 per 100 shares, roughly 9.9% of the protected share value.

There are compelling reasons for money managers and lenders to consider reducing their exposure. An MIT initiative report this year indicated that a staggering 95% of organizations are currently seeing zero return from their generative AI projects. The technology industry, historically characterized by rapid change, has seen once-dominant firms like Digital Equipment Corp. fade into obsolescence. Bonds that appear secure today could become significantly riskier or even default over time, especially if the expected profits from data centers fall short of current corporate projections. Credit default swaps tied to Meta Platforms Inc. began active trading for the first time recently, following its substantial bond sale. Similarly, derivatives linked to CoreWeave saw increased trading after the AI computing power provider lowered its annual revenue forecast due to a customer contract delay, leading to a Monday stock tumble.

The high-grade single-name credit derivatives market experienced greater volume before the financial crisis, with proprietary bank traders, hedge funds, and bank loan book managers utilizing these products to manage risk. However, post-Lehman's demise, trading volume in single-name credit derivatives decreased, and market participants believe it is unlikely to revert to pre-financial crisis levels due to the availability of more diverse hedging instruments, such as corporate bond exchange-traded funds, and increased liquidity in credit markets driven by electronic trading.

Sal Naro, Chief Investment Officer of Coherence Credit Strategies, who manages $700 million in assets, perceives the recent uptick in single-name CDS trading as temporary, describing it as a "blip" driven by data center build-outs. Yet, traders and bank strategists confirm that activity is currently on the rise. According to Barclays' Patel, the overall volume for credit derivatives linked to individual companies has increased by approximately 6% over the six weeks ending November 7, reaching about $93 billion, compared to the same period a year prior. Dominique Toublan, head of US credit strategy at Barclays, stated, "Activity has picked up. There's definitely more interest."